Three factors that shaped the monetary policy

Three factors have shaped the outlook and monetary policy for 2011-12. First, global commodity prices, which have surged in recent months are, at best, likely to remain firm and may well increase further over the course of the year. This suggests that higher inflation will persist and may indeed get worse.

Second, headline and core inflation have significantly overshot even the most pessimistic projections over the past few months. This raises concerns about inflation expectations becoming unhinged.

The third factor, one countering the above forces, is the likely moderation in demand, which should help reduce pricing power and the extent of pass-through of commodity prices. This contra trend cannot be ignored in the policy calculation. However, a significant factor influencing aggregate demand during the year will be the “fiscal situation”.

The budget estimates offered reassurance of a fiscal rollback. However, the critical assumption that petroleum and fertilizer subsidies would be capped, is bound to be seriously tested at prevailing crude oil prices. Even though an adjustment of domestic retail prices may add to the inflation rate in the short run, the Reserve Bank believes that this needs to be done “as soon as possible”. Otherwise, the fiscal deficit will widen and will counter the moderating trend in aggregate demand.

The latter portion of the third factor is the operative and crucial part which shapes the monetary policy outlook for the current fiscal. The RBI is in a hurry to pass-through the high oil prices to consumers. Otherwise, navigating inflation to a soft landing of 6 per cent at end March 2012 would end up as an unfinished agenda for the central bank.

The monetary policy trajectory that is being initiated in this annual statement is based on the basic premise that over the long run, high inflation is inimical to sustained growth as it harms investment by creating uncertainty. Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run, “should take precedence”.