The Reserve Bank of India (RBI) on Monday said that high inflation was likely to persist over the next couple of months before moderating as falling global commodity prices so far has been offset by rupee depreciation.
Second quarter review
“Incomplete pass-through is likely to limit the impact of falling global commodity prices. Financialisation of commodities leaves future commodity price path uncertain,” the RBI said on the eve of its half-year policy review. The RBI released the Macroeconomic and Monetary Developments of Second Quarter Review 2011-12. The document serves as a background to the Monetary Policy Statement 2011-12 to be announced on Tuesday.
Domestic price pressures still remain significant and broad-based. Food inflation is likely to stay elevated due to demand-supply mismatches in non-cereals and large MSP revisions. Real wage inflation has extended into first quarter of 2011-12. “In sum, the RBI said, “the inflation challenge remains significant”.
It said that volatility was high in global financial markets in the second quarter of 2011-12. Rising risk aversion caused credit spreads to widen. “Volatility spillovers impacted domestic currency and equity markets in a limited way”. Rupee depreciation and the fall in equity indices in the second quarter of 2011-12 were comparable to the patterns in most other emerging markets. Money market rates remained in line with policy signals, while G-Sec (Government Securities) yields hardened after the announcement of additional market borrowing.
The RBI said that “while inflation remains sticky, growth risks add to policy complexity”. The baseline inflation path still remains sticky and broadly unchanged from earlier projections. On the other hand, growth risks have increased on account of global headwinds and domestic factors. On current assessment, growth in 2011-12 is likely to moderate slightly from that projected earlier.
While persistent high inflation is impacting growth, investment is slowing down. The fall in new corporate fixed investment since the second-half of 2010-11 has been significant and can impact the pipeline investment in coming years. Inflation risk, however, persists. “The policy choices have become more complex”. In this backdrop, the monetary policy trajectory will need to be guided by the emerging growth-inflation dynamics even as transmission of the past actions is still unfolding.
Various surveys conducted, both by the Reserve Bank and outside agencies, suggest that business expectations have suffered, while inflation expectations remain high.
As a further step for increased transparency in monetary policy formulation, the RBI for the first time is releasing surveys conducted by it along with the ‘Macroeconomic and Monetary Developments', one day ahead of the policy. Growth in 2011-12 is likely to moderate to below trend. Agriculture prospects remain encouraging with the likelihood of a record kharif crop. However, moderation is visible in industrial activity and some services.
In addition to domestic factors, global factors may slow down growth. With the increasing linkage of domestic industrial growth with global industrial cycle, some further moderation is likely ahead, given the weak global PMIs. Capacity constraints seem to be easing in some manufacturing segments, especially cement, fertilizers and steel. Construction activity has slowed and leading indicators suggest that going forward, services growth may slightly weaken.
The RBI said that investment demand was softening as a result of combination of factors, including monetary tightening, hindrances to project execution, deteriorating business confidence and slowing global economy.
Private consumption is also starting to soften in parts, but it remains robust overall as is evident from corporate sales performance. Sales growth continues to be healthy, but profits are under pressure. However, it said, “Fiscal slippages during 2011-12 may complicate the task of aggregate demand management. Key to growth sustainability lies in supporting investment by rebalancing demand from government consumption to public and private investment”.
The RBI said that Current Account Deficit (CAD) widened in the first quarter of 2011-12, despite a surge in exports and higher net invisible receipts. Going forward, exports could decelerate as global growth slows down. Invisible earnings may also decelerate as slowdown in U.S. and euro area could impact software exports.
Sharp decline in foreign institutional investment (FII) flows in the second quarter of 2011-12 has been largely offset by strong FDI flows. However, capital flows are entering an uncertain phase with increased financial stress and worsening global growth prospects. “External sector outlook, although stable, warrants close monitoring”.
Bank credit growth is presently above the indicative trajectory. This has been supplemented by increased resource flows from non-banking sources.
Monetary policy has been significantly tightened since February 2010 with an effective increase of 500 basis points in policy rates and a 100 basis point increase in cash reserve raio (CRR); “but monetary transmission is still unfolding and real interest rates remain low and non-disruptive to growth”.
