Credible fiscal consolidation will be key to shaping inflation outlook

The Reserve Bank of India (RBI), on Thursday, kept the indicative rates unchanged as concerns about inflation pressures persist.

The RBI also indicated that it would not hike the rates but was not certain when it would be lowered. It said: “Recent growth-inflation dynamics have prompted the Reserve Bank to indicate that no further tightening is required and that future actions will be towards lowering the rates.”

Further, it cautioned that “notwithstanding the deceleration in growth, inflation risks remain, which will influence both the timing and magnitude of future rate actions.” Notably, Consumer Price Index (CPI) inflation for January 2012 was 7.7 per cent “suggesting that price pressures persist at the retail level.”

While most indicators suggest that the economy is slowing down, the performance in the fourth quarter of 2011-12 is expected to be better than that in the third quarter. Inflation has broadly evolved along the projected trajectory so far. However, the RBI said, upside risks to inflation had increased from the recent surge in crude oil prices, fiscal slippage and rupee depreciation. Besides, there continued to be significant suppressed inflation in fuel, fertilizer and power as administered prices did not fully reflect the costs of production.

The RBI's move was a similar one reflecting its mid-quarter review in December last. Till then, it had followed a tight money policy. The RBI left the interest rates unchanged in its mid-quarter review in December after raising them 13 times between March 2010 and October 2011.

Cash Reserve Ratio

However, the apex bank was conscious of providing liquidity to the system by cutting the Cash Reserve Ratio (CRR) in its third quarter review by 50 basis points from 6 per cent injecting a liquidity of Rs.31,500 crore into the banking system. This was the first move in the CRR since it was increased to 6 per cent from 5.75 per cent in April 2010.

Further, surprisingly, last Friday, the central bank reduced the CRR sharply by 75 basis points from 5.5 per cent to 4.75 per cent with effect from March 10, 2012. This reduction would inject around Rs.48,000 crore of primary liquidity into the banking system. The RBI justified its measures by saying that this was “to ensure smooth flow of credit to productive sectors of the economy.” “This measure was necessitated ahead of the scheduled Mid-Quarter Review to address the persistent structural liquidity deficit beyond the Reserve Bank's comfort level, which would have further worsened during the week of March 12-16 due to advance tax outflows,” the RBI said on Thursday.

The RBI also said that the reduction in CRR by 125 basis points (50 basis points effective January 28 and 75 basis points effective March 10), injecting primary liquidity of about Rs.80,000 crore has improved the liquidity situation and it was expected to ease further in the weeks ahead.

CRR is the percentage of deposits that commercial banks must keep with the central bank. The RBI also decided to keep its indicative short-term rate (repo rate) unchanged at 8.5 per cent while keeping the CRR at 4.75 per cent. Consequently, the reverse repo rate will remain unchanged at 7.5 per cent and the marginal standing facility (MSF) rate and the Bank Rate at 9.5 per cent.

Repo rate is the rate at which banks borrow money from the central bank and reverse repo is the rate at which banks park their funds with the central bank.

Fiscal concerns

As the government will announce its Budget for 2012-13 on Friday, the RBI reiterated its concerns on the Centre's fiscal conditions, which deteriorated during 2011-12 (April-January) with key deficit indicators already crossing the budget estimates for the full year.

Apart from sluggishness in tax revenues, government's non-Plan expenditure, particularly subsidies, increased sharply.

“As indicated in the third quarter review, the slippage in the fiscal deficit has been adding to inflationary pressures.

Credible fiscal consolidation, therefore, will be an important factor in shaping the inflation outlook,” the RBI added.

While the growth of merchandise exports decelerated, moderation in imports growth was less pronounced, leading to a widening of the trade deficit. After the third quarter review, the rupee has moved in a range of 48.69-50.58 per U.S. dollar. With sluggish demand conditions in the advanced economies impeding exports growth and rising crude oil prices, current account deficit (CAD) is likely to remain high. The financing of the CAD will continue to pose a challenge so long as the global situation remains uncertain.

Keywords: Interest rateinflationCRRRBI

More In: Economy | Business