It’s been two months since the Monetary Policy Committee (MPC) met and decided to raise the repo rate (at which the Reserve Bank of India (RBI) infuses liquidity) by 25 basis points to 6.25%. The rate hike was then seen as mostly pre-emptive. The economy was chugging along nicely, with both demonetisation and goods and services tax (GST) woes largely behind, and inflation was under control.Sure, the rupee was depreciating. But it was below Rs 70 to the dollar. There were some rumblings on the trade front, but those were early days. The yield on 10-year US treasury bills had not yet hit 3% (they would do so on the morning of August 1, US time, after the MPC meeting had concluded), suggesting the Fed would stick to three rate hikes in 2018. The monetary policy statement did not quite say, ‘God’s in his heaven, all’s well with the world’. But there was no mistaking the overall sense of satisfaction with the way macro-fundamentals were shaping up.How Red is My RupeeTwo months down the line, the picture could not be more different. The gentle depreciation of the rupee against the dollar has given way to a more rapid, and unruly, fall, depreciating almost 6% over the past two months. If the fall was initially driven almost entirely by the contagion effect of developments in Turkey and Argentina, the widening current account deficit (CAD) has contributed to the bearish sentiment more recently.Fortunately, sense has since returned to the currency market. But for RBI, the reprieve from financial sector woes was short-lived. By end-September, Infrastructure Leasing & Financial Services (IL&FS), the ‘systemically important’ non-banking financial company (NBFC), had all but collapsed, with a host of its subsidiaries defaulting on repayments. As fear replaced the earlier ebullience, stock markets turned skittish and the BSE Sensex fell more than 1,100 points on September 21.Overnight, yesterday’s darlings, non-banking finance companies, became pariahs. Their shares have been hammered down mercilessly, and no one is willing to lend to them. With liquidity turning tight, thanks to advance tax payments, RBI’s market intervention in support of the rupee (sale of dollars drains rupees from the system) and its fetish for keeping liquidity tight, there is now a real danger that troubles in IL&FS could spread and imperil financial stability.Alas, troubles never come singly. So, even as RBI and GoI battled to prevent the contagion effect, if necessary by infusing liquidity, US-China trade wars intensified, oil crossed $80 a barrel and the US Federal Reserve raised the Fed rate by 25 basis points to 2-2.25%, the highest in a decade. Worse, the accompanying statement left no one in any doubt that it would hike interest rates again in December 2018.The underlying message was clear. The Fed would not risk any overheating of the US economy. Emerging markets had best watch out for themselves.What does all this mean for the MPC when it meets later this week? If external vulnerabilities, the result of a widening CAD and exit of portfolio investors to safe haven avenues are not to coalesce into a larger economic problem, it has only one option: hike interest rates, like many emerging markets, including more recently, the Philippines and Indonesia.Remember, the combination of rising oil prices and a depreciating rupee also makes for a deadly cocktail as far as inflation is concerned. The case for a rate hike is, therefore, indisputable. The only question is whether it should hike by 25 basis points or 50 basis points.Inflate Your RoleAt a time when liquidity is already tight, this is not going to be an easy decision. It certainly won’t do anything for RBI’s popularity. But there are times when tough love is needed. This is one such occasion.Much more than rate action, RBI must devote greater attention to its regulatory and supervisory roles. Ever since it shifted to a formal ‘inflation targeting’ regime, these have not received their due attention. Indeed, the post of deputy governor in charge of commercial banking was left vacant for close to a year after previous incumbent, S S Mundra, retired, with the result that RBI’s top echelon was sadly wanting in practical knowledge of banking.Good regulation is like good parenting. It is important to lay down rules or boundaries (sensible ones) beyond which transgression will not be appreciated, or tolerated. But as any wise parent will tell you, it is equally —if not more — important to know when to apply the rules and when to be flexible. By that criterion, RBI has been a complete failure. It laid down strict, often unrealistic, rules and refused to show any flexibility. Regardless of extenuating circumstances or banks’ pleas.Sadly, RBI’s inability to see the big picture has cost the economy dear. With so many banks on prompt corrective action (PCA), bank lending has been squeezed. Apart from slowing down investment, this led to borrowers turning to NBFCs, where the same story of aggressive lending, followed by defaults, has been repeated. With much less accountability.Clearly, it is time RBI stopped thinking in silos and began to think beyond interest rates. Time, perhaps, for a dose of its own medicine, some PCA?