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Continuing worry over inflation

Bereft of major surprises, the Reserve Bank of India's first quarterly review of the monetary policy for 2006-07 will, like the previous policy statements, be relied upon for its authoritative analysis of the broad macroeconomic trends. An increase by 0.25 percentage point in the reverse repo rate — the rate at which the central bank absorbs liquidity — and a corresponding identical increase in the repo rate are the only monetary measures of note. It is for the second time in successive months that these rates, which have emerged as the key instruments of an increasingly flexible monetary policy, have been hiked. The financial markets had, however, widely anticipated the latest increase. Over the past few months there has been a general hardening of interest rates on both advances and deposits of the banking system and the long-dated bonds had factored in the increase. The key question as to whether and in what time frame the RBI will nudge the interest rates upwards again obviously depends upon its reading of the macroeconomy, especially inflationary expectations. Significantly, while retaining both its GDP growth forecast for 2006-07 at between 7.5 and 8 per cent and its targeted range of inflation (between 5.0 and 5.5 per cent), the RBI has pointedly stressed the need for appropriate policy responses to contain inflation.

Apart from a number of well-recognised concerns emanating from the domestic economy, global factors count more than ever before. High petroleum prices, recently aggravated by geo-political tensions, remain the biggest risk. The recent increase in food prices in India follows global trends. That, along with the increase in the cost of industrial raw materials, has become a significant factor impinging on domestic inflation. Money supply, deposits, and credit growth are well ahead of projections. Non-food credit has grown by 32.9 per cent on a year-on-year basis, despite the recent rise in interest rates. In its annual policy statement, the RBI had been selective in increasing the cost of bank lending to real estate and to certain other categories of retail loans. Although it is still early to make a precise assessment, indications are that those restraints have had no appreciable impact: banks continue to favour those sectors that have shown the characteristics of a bubble in other countries. Economic outlook for the rest of the year is altogether positive. Corporate performance remains reasonably robust. There is a pick up in investment and business confidence remains high. Export growth remains strong and, despite the higher petroleum bill, the balance of payments is comfortable. Invisible earnings and capital inflows have helped in bridging the deficit while adding to the reserves. At the global level, in addition to the oil prices, there are threats in the form of a disorderly unwinding of global imbalances and a hardening of interest rates. All these trends, which the RBI had cautioned about in April, seem to be materialising in varying degrees. In its latest stance, the RBI joins several other central banks — including the U.S. Federal Reserve and the Bank of Japan — who have responded to the current situation with interest rate rises.

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