Milton Friedman was the most famous economist of the second half of the twentieth century. He believed that inflation is a monetary phenomenon. As he wrote in Money Mischief – Episodes in Monetary History: “The recognition that substantial inflation is always and everywhere a monetary phenomenon is only the beginning of an understanding of the cause and cure of inflation.”

This line of thinking has influenced many economists over the years, ‘particularly’ those who work and teach at the University of Chicago, where Friedman was based for 31 years between 1946 and 1977.

Raghuram Rajan, currently the chief economic advisor and is scheduled to take over as the next governor of the Reserve Bank of India (RBI), is one such economist. In fact, Rajan has clearly pointed out in his earlier writings that the RBI should simply concentrate on managing inflation.

As Rajan wrote in a 2008 article, along with Eswar Prasad: “The RBI already has a medium-term inflation objective of 5%... But the central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective, but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”

And given this, the RBI ends up being neither here nor there. As Rajan put it: “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”

Hence, Rajan felt that the RBI should ‘just’ focus on controlling inflation. As he wrote in the 2008 Report of the Committee on Financial Sector Reforms: “The RBI can best serve the cause of growth by focusing on controlling inflation and intervening in currency markets only to limit excessive volatility... an exchange rate that reflects fundamentals tends not to move sharply, and serves the cause of stability.”

The trouble is that the RBI has moved on from a single-minded focus on inflation since the days of Bimal Jalan and tends to follow what experts refer to as the ‘multiple indicator approach’. The central bank now looks at a range of indicators from inflation to capital flows and even the exchange rate. Though at times the objectives the RBI is trying to achieve, are at odds.

This is what is happening currently. The RBI is trying to control inflation, accelerate economic growth and stabilise the value of the rupee, all at the same time. Something which is not possible. Rajan understands this well enough. “The RBI’s objective could be restated as low inflation, and growth consistent with the economy’s potential. They amount to essentially the same thing! But it would let the RBI off the hook for targeting the exchange rate. And that is the key point,” Rajan wrote in the 2008 article cited earlier.

Rajan’s writing suggests that he believes in letting the currency finding its right value. This puts him at odds with the current RBI policy of defending the rupee at around 60-61. If he allows the rupee to fall and find its right value, it would make him terribly unpopular with the political class. Also, do nothing might be a good theoretical strategy, but an RBI governor needs to be seen doing something to defend the rupee.

A weaker rupee would mean higher oil prices, for one. These higher prices would have to be passed on to the consumers in the form of higher price of petrol, diesel, cooking gas etc. With the Lok Sabha elections due in mid 2014, this would be politically disastrous for the Congress-led UPA.

Also, it’s worth remembering that there is not much a central bank governor can do about high consumer price inflation in India, given that most of it has come about from increased government expenditure, which more than doubled (gone up by 133%) to Rs 16,65,297 crore between 2007-2008 and 2013-2014. 

In fact, inflation might only go up once the food security scheme is in full swing. A tough test lies ahead for Rajan. But given his impeccable credentials, he might just be the best man for the job. As Turkish-American economist Dani Rodrik put it: “In Rajan, India gets a superb economist as its central bank governor.”

Rajan himself realises the challenges  and the fact there are no “magic wands” to cure the problems. He also realises the limited power of a central banker. As he wrote in an October 2012 column for Project Syndicate, “Central bankers nowadays enjoy the popularity of rock stars, and deservedly so... But they must be able to admit when they are out of bullets. After all, the transformation from hero to zero can be swift.”