‘Monetary actions will need to balance growth risks and inflation'

The Reserve Bank of India (RBI) on Monday warned that inflation risks persisted while growth outlook and business climate had weakened.

“The growth outlook has weakened........Inflation and expectations of inflation remain high. Upside risks emanate from exchange rate pass-through, revisions in administered prices and higher-than-expected government revenue spending,” said RBI on the eve of its third quarter monetary policy review on Tuesday.

The RBI left interest rates unchanged in its mid-quarter review in December after raising them 13 times between March 2010 and October 2011. While some market participants argued for a rate cut in its third quarter review, others said the central bank is likely to keep policy rates on hold.

“Monetary actions will need to strike a balance between risks to growth and inflation,” said RBI. Growth in 2011-12 is moderating more than was expected earlier. The business climate has weakened. The slack in investment and net external demand may keep the pace of recovery slow in 2012-13.

However, the RBI hopes that in the short-run, moderating inflation will provide some space for monetary policy to address growth concerns. “This will be, at best, a temporary respite.”

Agricultural prospects

The RBI said that agricultural prospects remained encouraging but moderation was visible in industrial activity and some services. “Industrial slackness has emerged as export and domestic demand has decelerated.” Growth in 2011-12 is likely to moderate to below trend, given the external conditions, dampened investment demand and prevailing high level of inflation.

The central bank felt that fiscal reforms, including the Direct Taxes Code (DTC) and the Goods and Services Tax (GST) were needed to contain deficits in 2012-13.

“The Central Government's deficit indicators are under duress due to higher subsidies and lower tax collections. Fiscal slippages during 2011-12 may complicate the task of aggregate demand management,” it added.

The apex bank said that current account deficit (CAD) risks had amplified as capital flows moderated. Early indicators suggest that the current account came under increased pressure during the third quarter of current financial year. Notwithstanding rupee depreciation, exports decelerated but import demand remained strong, with inelastic demand for oil and rising gold imports.

“Upward risks to CAD have become more pronounced with likely moderation of software earnings,” said RBI, adding, “As capital flows also moderated since August 2011, financing pressure on the CAD translated into exchange rate pressures.” Indian rupee had witnessed a sharp fall against the U.S. dollar in this period.