Inflation and inflationary expectations were the concerns of the Reserve Bank of India (RBI) Governor D. Subbarao when he announced the monetary policy for 2010-11. A policy shift from growth to inflation was widely accepted by the central bank as well as bankers.
“We reacted to inflation slowly,” Dr. Subbarao admitted while addressing a press conference last Tuesday at the RBI headquarters. “The developments on the inflation front are, however, worrisome,” he added.
Headline wholesale price index (WPI) inflation accelerated from 1.5 per cent in October 2009 to 9.9 per cent by March 2010. There has been a significant change in the drivers of inflation in recent months. What was initially a process driven by food prices has now become more generalised. This is reflected in non-food manufactured products inflation rising from (-) 0.4 per cent in November 2009 to 4.7 per cent in March 2010.
Going forward, three major uncertainties cloud the outlook for inflation. First, the prospects for the monsoon in 2010-11 are not yet clear. Second, crude prices continue to be volatile. Third, there is evidence of demand side pressures building up. On balance, keeping in view domestic demand-supply balance and the global trend in commodity prices, the baseline projection for WPI inflation for March 2011 is placed at 5.5 per cent.
However, inflation is hovering near double digit at 9.9 per cent, well above RBI's fiscal-end (2009-10) projection of 8.5 per cent. Food inflation moved up further to 17.65 per cent for the week ended April 10 from 17.22 per cent in the previous week as prices of essential items such as rice, milk, fruits and vegetables are continuing to rule high.
The RBI's policy stance for 2010-11 has been guided by three major considerations:
First, recovery is consolidating. The quick rebound of growth during 2009-10 despite failure of monsoon rainfall suggests that the Indian economy has become resilient. Growth in 2010-11 is projected to be higher and more broad-based than in 2009-10. In its third quarter review in January, the Reserve Bank had indicated that its main monetary policy instruments are at levels that are more consistent with a crisis situation than with a fast recovering economy.
In the emerging scenario, lower policy rates can complicate the inflation outlook and impair inflationary expectations, particularly given the recent escalation in the prices of non-food manufactured items. Despite the increase of 25 basis points each in the repo and reverse repo rates to 5.25 per cent and 3.75 per cent respectively, the real policy rates are still negative. It also increased the cash reserve ratio (CRR) of banks by 25 basis points from 5.75 per cent to 6 per cent effective fortnight beginning April 24, 2010. As a result of the increase in the CRR, about Rs. 12,500 crore of excess liquidity will be absorbed from the system. “With recovery now firmly in place,” said Dr. Subbarao, “We need to move in a calibrated manner in the direction of normalising our policy instruments.”
Second, inflationary pressures have accentuated in the recent period. More importantly, inflation, which was earlier driven entirely by supply side factors, is now getting increasingly generalised. There is already some evidence that the pricing power of corporates has returned. With the growth expected to accelerate further in the next year, capacity constraints will re-emerge. Inflation expectations also remain at an elevated level.
“There is a need to ensure that demand side inflation does not become entrenched.” Third, notwithstanding lower budgeted government borrowings in 2010-11 than in the year before, fresh issuance of securities will be 36.3 per cent higher than in the previous year. “This presents a dilemma for the Reserve Bank.” While monetary policy considerations demand that surplus liquidity should be absorbed, debt management considerations warrant supportive liquidity conditions. The Reserve Bank has to do a fine balancing act and ensure that while absorbing excess liquidity, government borrowing programme is not hampered.
The expected outcomes of these actions are: Inflation will be contained and inflationary expectations will be anchored; the recovery process will be sustained; government borrowing requirements and the private credit demand will be met; and policy instruments will be further aligned in a manner consistent with the evolving state of the economy.
Exchange rate and inflation
In his policy announcement, Dr. Subbarao also sent a warning signal on sharp and volatile exchange rate movements. Recent experience has underscored the issue of large and often volatile capital flows influencing exchange rate movements against the grain of economic fundamentals and current account balances.
“There is, therefore, need to be vigilant against the build-up of sharp and volatile exchange rate movements and its potentially harmful impact on the real economy, Dr. Subbarao warned.
