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Government, RBI must use the space provided by the Fed decision to set their own house in order.
The US Fed's decision to postpone a reduction in the monetary stimulus, or tapering, as it has come to be known, gives India breathing space for a few months. This should, however, be treated as an opportunity to set our house in order, knowing full well that the Fed's decision is only to delay cutting down on the stimulus it is providing, not to never reduce it. In June, Bernanke had indicated that the stimulus would be reduced when the US unemployment rate went down. The new data shows that while jobs have increased, the unemployment rate went down due to a reduction in labour force participation. This has complicated the story of the US recovery. Further, there appear to be signs that the US government would have to cut down spending further. This "fiscal drag" on the US economy would also mean that growth may be slower than expected earlier. As a consequence, instead of starting the tapering now, the Fed decided to wait until it was more certain that the stimulus was no longer required.
Markets and currencies have reacted with enthusiasm, and the rupee has appreciated. The rupee depreciation India witnessed after Bernanke's June statement has been reversed to a large extent. Looking ahead, there are two tasks. In the short term, the RBI must reverse all the retrograde steps taken in the last two months. Many of those measures were non-transparent and led to a breakdown of the operating framework of monetary policy. Whatever is done now, therefore, must be done in a transparent framework, with price signals rather than quantitative restrictions. The second task is to ensure that the next time there is volatility in emerging economy currency markets and the rupee goes sharply up or down, we do not see the kind of knee-jerk reaction that was observed this time. Central bank communication is one of the most important tools of monetary policy. This tool should be used by the RBI to give guidance to the markets on what to expect. Measures to restrict participation in currency futures should be reversed.