Let us mellow down somewhat, however, and analyze the matter with reference to a recent policy document, the Annual Policy Statement for the Year 2010-11 released on April 20, 2010 by the Governor of RBI. To quote the Governor:

"On balance, under the assumption of a normal monsoon and sustenance of good performance of the industrial and services sectors on the back of rising domestic and external demand, for policy purposes the baseline projection of real GDP growth for 2010-11 is placed at 8.0 per cent with an upside bias."

As opposed to this, the Central Budget document states:

"GDP for BE 2010-11 has been projected at Rs. 69,34,700 cr, which assumes a 12.5 per cent growth over the advance estimates 2009-10 (Rs. 61,64,178 cr) released by CSO."

The Finance Ministry, in other words, has based its calculations for the current financial year on the assumption of a 12.5 per cent nominal rate of growth of GDP and the RBI expects this nominal growth rate to translate into a real growth rate figure of 8 per cent. For consistency between the two estimates, the rate of inflation for the year should be 12.5 - 8 per cent = 4.5 per cent.

The current annual rate of inflation is close to 10 per cent. So, the challenge before our policy makers is to reduce the rate of inflation to less than half its present level. It is therefore not surprising that the Annual Policy Statement puts most of its emphasis on inflation control. 

To quote the Governor again:

"Going forward, three major uncertainties cloud the outlook for inflation. First, the prospects of the monsoon in 2010-11 are not yet clear. Second, crude prices continue to be volatile. Third, there is evidence of demand side pressures building up. On balance, keeping in view domestic demand-supply balance and the global trend in commodity prices, the baseline projection for WPI inflation for March 2011 is placed at 5.5 per cent."

Once again, for consistency with the projected real growth rate figure, this requires the nominal GDP to grow at the rate 13.5 per cent, as opposed to the Finance Ministry's assumption of 12.5 per cent. Whichever way one wishes to look at it, there is clearly a serious problem before our policy makers. 

How does one achieve this goal? In this context, the RBI Governor has also drawn our attention to the risks lying ahead. He has made four crucial observations that are worth taking noting. These are:
1. The pace of global recovery is still uncertain. Recent events in Greece and Spain prove that his observation is well-founded. He notes that fiscal stimulus measures, or demand management played a major role in the recovery process in many countries. The Governments engaged in public works programmes to compensate for the fall in private demand in major advanced economies. They were suffering from high unemployment rates, weak income growth and tight credit conditions. There is a risk therefore that once the impact of public spending wanes, the recovery process will be stalled. Therefore, the prospects of sustaining the recovery hinge strongly on the revival of private consumption and investment. While recovery in India is expected to be driven predominantly by domestic demand, there are indications that a sluggish and uncertain global environment can adversely impact the Indian economy.
2. If the global recovery does gain momentum, commodity and energy prices, which have been on the rise during the last one year, may harden further. Increase in global commodity prices could, therefore, add to inflationary pressures.
3. From the perspective of both domestic demand and inflation management, the 2010 south-west monsoon is a critical factor. The current assessment of softening of domestic inflation around mid-2010 is contingent on a normal monsoon and moderation in food prices. Any unfavourable pattern in spatial and temporal distribution of rainfall could exacerbate food inflation. In the current context, an unfavourable monsoon could also impose a fiscal burden and dampen rural consumer and investment demand.
4. Finally, it is unlikely that the large monetary expansion in advanced economies will be unwound in the near future. Accommodative monetary policies in the advanced economies, coupled with better growth prospects in EMEs including India, are expected to trigger large capital flows into the EMEs. The rupee has appreciated sharply in real terms over the past one year. Pressures from higher capital flows combined with the prevailing rate of inflation will only reinforce that tendency. Both exporters, whose prospects are just beginning to turn, and producers, who compete with imports in domestic markets, are getting increasingly concerned about the external sector dynamics.
What was the monetary policy stance of the RBI in the recent past?
Since October 2009, the RBI's policy has been calibrated to India’s specific macroeconomic conditions and these in turn have motivated the announced policy stance for 2010-11.
1. There was a rebound of growth during 2009-10 despite the failure of monsoon. The policy makers believe this to be a proof that the Indian Economy has gained in resilience. Consequently, growth in 2010-11 is projected to be higher and more broad-based than in 2009-10. As per the Third Quarter Review in January 2010, the RBI had indicated that its main monetary policy instruments were at levels that were more consistent with a crisis situation than with a fast recovering economy. In the scenario that appears to be emerging now, low policy rates can worsen the inflationary outlook. This perception is driven by the recent escalation in the prices of non-food manufactured items. And, according to the Governor, this is partly due to the fact that despite the earlier increase of 25 basis points each in the repo rate and the reverse repo rate, the real policy rates were still negative. Now that recovery appeared to be afoot, a calibrated tightening in the direction of normalising our policy instruments was in order.
2. There is some evidence that the pricing power of the corporates has returned. With the growth expected to accelerate further in the next year, capacity constraints will re-emerge and this could exert further pressure on prices. Inflation expectations also remain at an elevated level. There is, therefore, a need to ensure that demand side inflation remains under control.
3. The Government plans to borrow less in 2010-11 than in 2009-10. Nonetheless, fresh issuance of securities will be 36.3 per cent higher than in the previous year. This could well be linked to the fact that higher borrowings have led to an upward pressure on the interest rate on bonds and a lowering of bond prices. As the Governor points out, this poses a dilemma for the Reserve Bank. While monetary policy considerations demand that surplus liquidity should be absorbed, debt management considerations warrant supportive liquidity conditions. The Reserve Bank, therefore, has to do a fine balancing act and ensure that while absorbing excess liquidity, the government borrowing programme is not hampered.
Motivated by these considerations, the Reserve Bank announced the following policy measures:
a) Bank Rate: The Bank Rate remains unchanged at 6.0 per cent.
b) Repo Rate: The  repo rate under the Liquidity Adjustment Facility (LAF) is raised by 25 basis points from 5.0 per cent to 5.25 per cent.
c) Reverse Repo Rate: The reverse repo rate under the LAF is raised by 25 basis points from 3.5 per cent to 3.75 per cent.
d) Cash Reserve Ratio:  The cash reserve ratio of scheduled banks is raised by 25 basis points from 5.75 per cent to 6.0 per cent of their net demand and time liabilities. This measure will absorb around Rs. 12,500 cr of excess liquidity from the system.
d) The RBI will continue to monitor macroeconomic conditions, particularly the price situation, closely and take further action as warranted.
As a result of these policy measures, the RBI expects:
(i)    Inflation as well as inflationary expectations will be contained.
(ii)   The recovery process will be sustained.
(iii)  Government borrowing requirements and the private credit demand will be met.
(iv)   Policy instruments will be further aligned in a manner consistent with the evolving state of the economy.
The obvious questions that all parties are asking now are:

First, can the recovery process be sustained with monetary tightening and second, can the Government borrowing requirements be met along with that of the private sector?
It is not clear that monetary measures alone would take care of inflation. The Governor has indicated that despite all the measures adopted, the monsoon will matter. Moreover, if the corporate sector is facing capacity constraints too as the Governor suspects, then a resurgence in demand will add to inflation rather than output and real growth.

The answer to the second question is even more difficult. Growth will surely increase the financing requirements of the Corporate sector and despite the lower projected fiscal deficit, the Government too will require more money. How can both these problems be addressed?

It is possible of course that greater flow of FII's will compensate for the lower supply of money in the system, but these cannot be depended on, being volatile in nature. Some experts have even indicated that the monetary tightening will not matter since there will still be enough liquidity in the system. If this is the case and if interest rates are not going to harden in spite of the recent measures announced, then demand will not be constrained. Consequently, demand pull inflation will still keep working.

It is very difficult to predict, based on economic arguments alone, what is coming up. If the Governor's hopes are fulfilled, we should feel happy. However, we need to sit and watch.

Ultimately, as we observed at the very beginning, it will be the monsoon that will be sitting in the driver's seat.

[This is a revised version of an invited lecture delivered to the Bankers' Summit held by the Indian Chamber of Commerce on May 10, 2010]