In a move that was widely anticipated, the Reserve Bank of India, in its second quarter review of the monetary policy, has hiked the repo and the reverse repo rates by 0.25 percentage point. Inflation remains high with both demand and supply factors at play. Inflationary expectations continue to be high. There is no ambiguity in the policy stance that the demand side pressures need to be contained and the inflationary expectations anchored. Though showing signs of moderation, WPI inflation at 8.6 per cent in September was well above the RBI's year-end target of 5.5 per cent. Existing inflationary pressures are likely to accentuate for several reasons. Global commodity prices, ruling high despite a weak recovery in the advanced economies, are poised to go up further due to strong demand from the emerging economies. The expected quantitative easing by the U.S. Federal Reserve will considerably add to the already high levels of global liquidity. In India, both property and equity markets have risen sharply. The RBI considers the growing “financialisation” of commodities as another potent risk to price stability. Persistently high domestic food inflation points to the existence of some structural component that will continue to weigh on the overall inflation. Finally, with the utilisation of domestic manufacturing capacity nearing its peak, demand side pressures might still increase. Although there is a strong case for a further rise in policy rates, the RBI has, so as not to jeopardise growth, ruled out any more action for now.

The RBI's forecast of GDP growth for 2010-11 remains pegged at 8.5 per cent, which is in line with most other official and non-official estimates. One major downside risk arises from the prospects of a slow and prolonged recovery in the advanced economies, many of which are severely indebted. Although India's exports as a percentage of the GDP are not large, a prolonged slump in world trade will impact negatively on manufacturing and services sectors. The ultra-loose monetary policies pursued by the U.S. and Japan have flooded the domestic markets and pose major policy challenges. The widening current account deficit is a matter of concern. Global capital flows which have so far helped bridge the deficit cannot be taken for granted. Along with the interest rate signals, the RBI has sought to discourage certain types of home loans by requiring the banks, for instance, to provide additional capital. For the first time, it has incorporated in its stance a provision to manage liquidity actively. Many categories of borrowers will have to pay more but the depositors, who are getting a negative return, will be compensated only partially.

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