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Room for flexibility

The Reserve Bank of India’s decision to keep its policy rates, the bank rate, the reverse repo and the repo rates as well as the cash reserve ratio (CRR) unchanged, reflects the several dilemmas it is facing simultaneously. The traditional one — of reconciling the objective of price stability with the needs of the real economy — obviously remains and is emphasised once again. However, on the eve of the latest credit policy statement, global cues seemed to engage attention in policy debates. More than at any time in the recent past, the monetary policy has to focus on the external sector, now accounting for 40 per cent of the GDP. Specifically, the lowering of interest rates in the United States in the wake of a massive 0.75 percentage point cut in the federal funds rate led most market participants to expect a reduction in rates by the RBI also. The reasoning, not entirely without merit in the context of the last week’s stock market meltdown, was that the U.S. initiative, in the absence of a corresponding cut in interest rates by the RBI, would increase the flow of portfolio and other funds to India in search of a higher return. However, domestic inflation — though running below its target of 5 per cent — continues to be a major cause for worry. Global oil prices remain high and have not yet been factored into domestic inflation figures. Besides, although the prices of primary food articles have come down recently, the outlook on the food front is still hazy. At the global level, prices of food grains, especially wheat and corn, are ruling at record levels and it is partly in response to this development the government sharply hiked the minimum support price for wheat due for harvest soon. Unless the subsidies are increased substantially, food prices are bound to go up even after a successful harvest.

Retaining its GDP forecast for 2007-08 at 8.5 per cent, the RBI, like many other central banks, views inflation as the biggest threat to macroeconomic stability. Its immediate aim is to contain inflation at close to 5 per cent while anchoring expectations in the region of 4 to 4.5 per cent. Money supply and bank deposits have continued to grow ahead of their targets. Growth in non-food credit has decelerated, partly as a result of the RBI’s directives to tighten lending norms for certain overheated sectors including real estate. The RBI would continue to emphasise credit quality and credit delivery particularly for employment-intensive sectors and pursue financial inclusion. By opting for the status quo in interest rates, the central bank has given itself some flexibility; it can choose to modify the rates at a later date, depending on exigencies arising from domestic and global developments.

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