It is not easy being a central banker these days. While capital inflows represent the increasing confidence in the Indian growth story, the sheer magnitude of the inflows is giving the Reserve Bank of India a migraine. The end-October review of monetary policy identifies three sets of challenges that the central bank sees as its main priorities: managing capital inflows and the attendant surplus liquidity, the escalation in asset prices of equities and real estate that looks dangerously like a bubble, and the potential increase in inflationary expectations that it is the RBI’s primary job to control. Until recently, the monetary authorities were doing a good job of meeting all three challenges. But now the magnitude of the tasks seems overwhelming.

Start with capital inflows. The RBI sought to both sterilize inflows by raising the amount of bonds that could be issued under the market stabilization scheme to Rs 200,000 crore. Suddenly that figure does not look adequate. The surplus liquidity absorbed through liquidity adjustment operations, MSS bonds and government balances with the RBI has almost tripled to Rs 222,582 crore in October from Rs 85,770 crore at end-March 2007. The RBI increased cash reserve requirements at end-July by half a percentage point, and again in October by another half per cent. In this financial year nearly Rs 54, 200 crore has been impounded through CRR, an increase of nearly two-and-a-half times over that absorbed in the same period last year. This amounts to money that carries a cost but earns nothing, rendering CRR and the MSS ineffective policy instruments. The escalation in asset prices in equities and real estate has been driven by hedge funds, pools of largely unregulated capital that the RBI believes heighten risks to the system and pose a threat to financial stability, even economic growth prospects. Inflation expectations are another headache. While the wholesale price index is low at 3 per cent, it does not reflect real oil prices that have been rising while domestic petrol prices have not been revised for almost 18 months. Since August, oil prices have gone up by 10 per cent. Consumer price inflation has also gone up by one per cent. William McChesney Martin, one of the longest serving chairmen of the Federal Reserve Board of the United States of America, would say that the central banker’s job was to take away the punch bowl just as the party was getting interesting. For the RBI, the hangover is preceding the party.