One of the unique features of the official response to the global financial market crisis is the pre-dominant role played by central banks everywhere, though the fiscal (government) response also has been notable. Therefore, one should not be surprised if, after the crisis blows over, central banks are assigned even greater responsibilities in economic management.

How effective and relevant, at the regional / local level in a vast country like India, can a monetary policy set in Mumbai be? While monetary policy (and more narrowly interest rate policy) is set in Mumbai based on some aggregate (all-India) financial statistics such as bank credit, deposits, wholesale and consumer price indices, do they capture regional and local economic trends at all?

Paradox in food prices...

It is the paradox in food prices which steals the immediate spotlight on this issue and demands a broader approach to price management.

The country is on the verge of a second bumper harvest of the main food crops - rice and wheat - and official food stocks also are at record levels. But it is also a fact that open market rice prices registered an increase of more than 50 per cent in the past 6 months. Rice now sells at close to Rs.40 per kg in the open market. There was, of course, a sharp increase in the minimum support price (MSP) for rice as well as other crops in 2008 of close to 40 per cent. In the case of rice, for example, the MSP has been fixed at Rs.900 per quintal and this represents a 38 per cent hike.

But, the significant divergence between the MSP of Rs.9 and the open market price of Rs.40 per kg shows that intermediation costs (milling and trading) are exorbitant. A more troubling aspect to this scenario is that even the government (CACP) admits that many farmers are not able to access the MSP.

Interest rates not appropriate...

This is clearly a situation where aggregate demand management by the central bank through interest rate hikes may not be relevant. Indeed, tackling food price inflation in this scenario does not mean that food demand has to be curbed. Given the fact that food demand is quite price- inelastic (particularly in a poor country like India), curbing food demand would be ultimately even welfare-reducing.

Setting interest rates in Mumbai to tackle high food price inflation in Chennai, therefore, does not appear to be meaningful. (It is interesting to note here that rather than interest rate hikes, rates are actually being cut officially in a determined manner to tackle the 'softness' in the aggregate WPI inflation. The anomaly appears to be quite stark as interest rate moves can have asymmetrical effects on prices, particularly at the local / regional level. That is, while interest rate hikes may not help soften food prices, rate reductions could aggravate price pressures).

Why will they aggravate price pressures?

Because, what is in play here are supply rigidities which are pushing open market prices up. These supply rigidities arise from 2 sources - one, the milling/ trade sector being able to hold large stocks of commodities purchased at the MSP (or even lower). Note that this ability to hold stocks will only be strengthened by lower interest rates - evidence of the asymmetrical effects mentioned above. Second, in the instant case, there seem to be restrictions on the inter-state (regional) movement of rice.

Rather than interest rate moves, it is possible that selective credit controls could be more appropriate here to bring price levels down. Selective credit controls (where credit to certain sensitive segments is limited) could be combined with fiscal measures such as stock holding limits set by government. A more region-specific measure could mean dismantling the restrictions on movement of agricultural produce.

Tackling the inflation paradox, therefore, would require more than the central bank tinkering with interest rates in Mumbai. The central bank's focus on inflation management is only a necessary component of overall inflation fighting policy, particularly in a country like India with significant diversities and supply rigidities.