As widely expected the Reserve Bank of India (RBI) raised the short-term indicative rate by 25 basis points to quench the flames of inflation. This is the tenth time since March 2010 the RBI raised the rate as inflation crossed the 9 per cent mark in May. But the market believes this hike was only a portion of the rise that the markets were expecting in the current financial year.
It increased the repo rate by 25 basis points from 7.25 per cent to 7.50 per cent with immediate effect. Consequently, the reverse repo rate under the Liquidity Adjustment Facility (LAF) will stand automatically adjusted to 6.50 per cent and the marginal standing facility (MSF) rate to 8.50 per cent with immediate effect.
While raising the rate, the RBI used strong words in its introduction. It stated that since the Reserve Bank's annual policy statement of May 3, global environment had changed for the worse, while domestic conditions were broadly consistent with the statement's projections. Growth expectations in advanced economies were visibly moderating, even as inflationary pressures, primarily from commodity prices, had increased. The capacity for conventional policy responses appeared limited, with many countries having already committed to fiscal consolidation amidst growing sovereign debt risks. From our monetary policy perspective, global commodity prices still remained the key external risk though some signs of moderation were becoming visible.
Domestically, inflation persists at uncomfortable levels. Moreover, the headline numbers understate the pressures because fuel prices have yet to reflect the rise in global crude oil prices. On the growth front, even as signs of moderation are visible in some sectors, broad indicators of activity — 2010-11 fourth quarter profit growth and margins and credit growth — do not suggest a sharp or broad-based deceleration.
In the current mid-quarter policy review, the central bank was more concerned on the global economy (sovereign debt crisis) and commodity prices. The global economy weakened in the second quarter of 2011. Lead indicators suggest that growth moderated in advanced and emerging market economies (EMEs) under the impact of high oil and other commodity prices, the spillover from the Japanese natural disaster and monetary tightening in EMEs to contain inflationary pressures.
Further, the memories of the 2007-08 global financial crisis are still fresh and haunting the policy makers. “Uncertainty about the resolution of the sovereign debt problem in the euro area has increased. These developments increase downside risks to global growth prospects,” said the RBI.
International commodity and oil prices showed signs of moderation on weak economic data and unwinding of financial positions. However, on a year-on-year basis, commodity price inflation is still high. Consequently, headline inflation rose in major advanced economies despite negative output gaps. As inflation in EMEs remained elevated due to high commodity prices and strong domestic demand, many EMEs persisted with monetary tightening during the second quarter of this calendar year to contain inflation. The Union Finance Minister, Pranab Mukherjee, also said that the major challenge right now was to contain price rise admitting that the growth process might have to take a back seat, which he was not ready to accept earlier. “Monetary measures may end up moderating the growth if they have to be persisted for an extended period of time.”
A look at the inflationary trend, as RBI explained, reveals it: The headline wholesale price index (WPI) inflation rate was 9.7 per cent in March 2011. In April, it was 8.7 per cent and rose to 9.1 per cent in May. The numbers for April and May are as yet provisional and, given the recent pattern, these numbers are likely to be revised upwards. Thus, the headline WPI inflation rate remains elevated, consistent with the projections made in the annual policy statement of May 3. The main drivers of WPI inflation in April-May were non-food primary articles, fuel group and non-food manufactured products. The consumer price inflation for industrial workers (CPI-IW) rose from 8.8 per cent in March to 9.4 per cent in April.
Non-food manufactured products inflation was 8.5 per cent in March. Provisional data indicate that it increased from 6.3 per cent in April to 7.3 per cent in May, much above its medium-term trend of 4 per cent. “This pattern in non-food manufactured products inflation is a matter of particular concern. Besides reflecting high commodity prices, it also suggests more generalised inflationary pressures; rising wages and costs of service inputs are apparently being passed on by producers along the entire supply chain”. The monetary policy stance remains firmly anti-inflationary, recognising that, in the current circumstances, some short-run deceleration in growth may be unavoidable in bringing inflation under control. This is a remarkable change from the central bank's earlier stance that “sustains growth in the medium-term by containing inflation”. However, the RBI will continue to maintain liquidity conditions such that neither surplus liquidity dilutes the monetary policy stance nor large deficit chokes off fund flows to productive sectors of the economy.
The rate hike in future is dependent upon the extent to which the current global uncertainties impact domestic growth. The RBI expects that this rate hike will result in “containing inflation and anchor inflationary expectations by reining in demand-side pressures and mitigate the risks to growth from potentially adverse global developments”. The markets are expecting another 50 basis points hike in the near future but in two stages of 25 basis points each.
