The objective of the Reserve Bank of India will be to condition an environment to bring inflation down to 4-4.5 per cent

The Annual Policy 2011-12 was substantially different from all other recent monetary policies announced by the Reserve Bank of India (RBI). While it stressed more on the current as well as future inflationary pressures and the ways and means to mitigate its horrors, the RBI decided to sacrifice the prevailing growth rate and cut that to 8 per cent for 2011-12 from the last year's 8.6 per cent.

A subdued RBI Governor D. Subbarao was at pains to explain how inflation would affect growth. He has also admitted that RBI failed to judge or foresee the inflationary pressures early, which even affected the credibility of the RBI.

Even though the trend of moderating inflation and consolidating growth in the second and third quarters of 2010-11 justified the calibrated policy approach of the central bank, the resurgence of inflation in the last quarter of 2010-11 was a matter of concern.

Economic stability

By dropping its earlier calibrated approaches, the RBI has entered a mission in this financial year to focus on economic stability by anchoring inflation expectation instead of sustaining growth momentum. It hiked the repo rate by 50 basis points from 6.75 per cent to 7.25 per cent, tightened some provisioning norms and there is also a 50 basis point increase in the interest rate on savings deposits from 3.5 per cent to 4 per cent.

While the RBI expects inflation to be close to 9 per cent in the first-half of the current fiscal that began in April, it has projected the headline number to moderate to 6 per cent by end-March 2012.

At present, inflation is hovering between 8 per cent and 9 per cent or close to 9 per cent, a high level as compared to RBI's target levels. The objective or the endeavour of RBI will be to condition an environment to bring inflation down to 4-4.5 per cent and to bring an environment in the medium term of 3 per cent inflation consistent with the global inflation scenario. Meanwhile, Chief Economic Advisor Kaushik Basu is hopeful that April headline inflation is expected to ease to 8.3 per cent. The number rose to 8.98 per cent in March from 8.31 per cent in the previous month.

RBI fixes grace period

Now the RBI has fixed a grace period for the rising prices to take a reverse trend, by “the first-half of the current year”. However the situation is very bearish and negative as global commodity prices are moving up and demand also is rising. Complexity in economic situation would reach its nadir once inflation remains near 9 per cent or above 8 per cent and growth momentum falls below 8 per cent as at end September 2011. The central bank's expectation of a growth momentum was based on the assumptions of a normal monsoon and global crude oil price of $110 a barrel. Once the present socio-political scenario in the Middle East and North African nations worsens, commodity prices would escalate further.

This annual policy has also surprised the markets. When the RBI signalled the market by raising the repo rate — the rate at which banks borrow funds from the central bank — by 50 basis points — the equity market dipped by 463.33 points or 2.44 per cent to 18534.69 with banking, real estate and automobile counters leading the decline on May 3. For the week ended May 6, it closed at 18518.81 compared to the previous week's close of 19135.96, a loss of 617.15 points. The market was expecting a rise of 25 basis points. However, the markets belatedly accepted the fact that the RBI's move clearly reflected its concern about rising prices. Hereafter RBI will have only one single policy rate, the repo rate, to indicate the rate changes in the banking system.

The significant changes announced by the RBI in its operating procedure of monetary policy are expected to bring in more clarity in the policy rates. Further, this would enhance the transmission of monetary policy and reduce volatility in overnight call money rates. The reverse repo rate (the rate at which banks park their funds with the central bank) will continue to be operative, but it will be pegged at a fixed 100 basis points below the repo rate. Hence, the reverse repo rate will no longer be an independent variable.

Further, the RBI has instituted a new Marginal Standing Facility (MSF). Banks can borrow overnight from the MSF up to one per cent of their respective net demand and time liabilities or NDTL. The rate of interest on amounts accessed from this facility will be 100 basis points above the repo rate. As per the newly introduced scheme, the revised corridor will have a fixed width of 200 basis points. The repo rate will be in the middle. The reverse repo rate will be 100 basis points below it and the MSF rate 100 basis points above it.

The RBI has demonstrated, as an aggressive central bank, with nine rate rises since March 2010, post-global financial crisis. But gradual policy tightening (a “baby step” of 25 basis points each) failed to quench the fuelling price rise.

With the “long step” of a rise by 50 basis points, tough conditions would prevail in the economy. Rising commodity prices, increased fuel subsidy, subsequent risk of overshoot in government borrowing and pressure on trade gap are factors which would make the central bank's task more difficult.

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