The Reserve Bank of India, in its annual policy statement released on April 20, has surprised the financial markets with its identical 0.25 percentage point increase in the two policy rates — the repo rate and the reverse repo rate — and in the cash reserve ratio.
On the eve of the policy announcement, there was widespread anticipation that the hike in these would be larger. This was because the RBI's monetary stance had, over the previous two quarters at least, shifted heavily towards maintaining price stability and reining in inflation, which had even six months ago become a major threat. The central bank's tone had turned ‘hawkish' about inflation.
Inflation, main concern
The report on the macro economic situation, released on the eve of the policy statement, bears testimony. Inflation had without doubt become the key problem and controlling it was the number one item on the policy agenda. That sentiment permeates the annual policy statement although the measures announced do not seem to reflect the intensity of the problem.
In January, in its third quarter review of last year's policy, the RBI raised the CRR by 0.75 percentage point, a magnitude that was higher than expected. Subsequently, in mid-March, the repo and reverse repo rates were raised by 0.25 percentage point each. That the RBI acted in between two scheduled dates of policy statements — this time between the third quarter review and the annual policy for 2010-11 — seemed to indicate its urgency.
But for quite some time now, the central bank has not been strictly acting within the confines of policy announcement dates. The idea is to impart flexibility to monetary policy and ‘surprise' market participants, if needed. The other objective is to demystify credit policies and make them ‘non-events'. The intent is to focus on developments in the macro economy without the distraction of having to constantly look out for adjustments in the CRR and repo rates.
Muted response
The relatively muted response to inflation this time is explained by the fact that the RBI can act any time. Besides, a mark-up in interest rates has other consequences. The central bank has to straddle several conflicting policy objectives. The classic dilemma that the RBI faces is to maintain price stability and simultaneously meet the credit needs of the real economy.
This time, there is another dilemma. Inflation containment would require draining of liquidity through a CRR hike or open market sale of securities. But the scale of government borrowings budgeted for 2010-11 is large and what is more, the deficit will be funded through issuance of fresh securities. So, the RBI has to do a fine balancing act: ensuring reasonable liquidity to fund the borrowing programme without fuelling inflation.
Uncertain factors
Headline WPI (wholesale price index) inflation accelerated from 1.5 per cent in October 2009 to 9.9 per cent by March this year. Besides inadequate supply of food and other essential commodities, a number of other factors are involved.
That inflation has become more generalised is seen from the fact that non-food manufactured products inflation has risen from (-) 0.4 per cent in November 2009 to 4.7 per cent in March.
The RBI's projection for WPI inflation for March 2011 is 5.5 per cent. There are a few uncertainties that cloud the outlook. One, the prospects for the southwest monsoon are not clear. Two, crude prices continue to be volatile. Three, demand side pressures are increasing and corporates are rediscovering their purchasing power.
The RBI's GDP growth forecast is among the earliest and the most widely watched official forecast. For 2010-11, the central bank estimates the economy to grow by 8 per cent. Economic recovery that began in the second quarter of 2009-10 has been sustained. Industrial recovery has become more broad-based and is expected to take firmer hold on the back of rising domestic and external demand. Exports and imports have picked up from November 2009 after declining for almost a year. Flow of resources to the commercial sector has increased from bank and non-bank sources. The RBI's forecast is based on a normal monsoon and vibrant industry and services sectors.
The monetary projections have been made consistent with growth and inflation outlook. Money supply growth in 2010-11 is placed at 17 per cent and aggregate deposits of scheduled commercial banks are projected to grow by 18 per cent. Non-food credit by scheduled commercial banks is expected to grow by 20 per cent.
The annual statement does not gloss over the risks that may shrink growth and increase inflation. One, global recovery depends on the revival of private demand which remains weak in advanced economies.
A sluggish global demand will have an adverse impact on India. Second, if global recovery takes place, commodity and energy prices may harden further. Three, an unfavourable monsoon could exacerbate food inflation and dampen consumer and investment demand. Four, the soft monetary policies that continue in the advanced economies will trigger large capital flows into India and other emerging markets. That in turn will pose significant challenges to exchange rate and monetary management.
