FINANCIAL SCENE
RBI sounds the alert on inflation
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A status quo on interest rates does not mean that the monetary stance of the apex bank is neutral
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While trying to balance several conflicting objectives simultaneously, the monetary policy review has cautioned against inflation. Sooner rather than later, the RBI will have to withdraw from its expansionary policies.
— PHOTO: KAMAL NARANG
KEEPING CLOSE VIGIL: Pulses displayed at a shop in New Delhi. As the global commodity prices are on a rebound and the uncertain monsoon outlook can further accentuate food prices, the RBI has revised upward its WPI inflation target for end March 2010 to 5 per cent.
The Reserve Bank of India’s first quarter review of the annual credit and monetary policy (2009-10) has not led to any change in the policy or statutory rates. The repo and reverse repo rates remain at 4.75 per cent and 3.25 per cent, respectively, and the cash reserve ratio at 5 per cent. There has hardly been any surprise as the central bank’s inaction on rates was widely anticipated.
Beginning last September the RBI, through a series of rate cuts and CRR reductions, had pumped in liquidity and signalled lower interest rates on bank loans. According to the review, there has been, since mid-September, an augmentation of liquidity of over Rs. 5,61,700 crore. Also, the markets have become used to the RBI announcing policy rate cuts and other measures even outside the policy reviews. There was no particular compulsion this time for a change in any of its monetary measures.
Scope for rate cuts
However, a status quo on interest rates does not mean that the monetary stance is neutral. A reading of the policy document shows that the RBI is wary of a resurfacing of inflation. If anything, the tone of the first quarter review is firm and a mark up in interest rates will come only after the central bank finds enough reasons to withdraw from its expansionary policies.
Taking stock of the present scenario, the review notes that abundant liquidity has increased the competitive pressure on banks to lower lending rates. While the monetary policy’s transmission mechanism has consequently improved since the annual policy statement in April, there is still scope for further reduction in rates by banks. One reason for this view is the fact that deposits contracted at high rates earlier are maturing. The new deposit rates — on renewal — are lower.
Major constraints
However, there are two major developments that may stand in the way of a cheaper money policy. The huge government borrowing programme is bound to create pressure on interest rates. The combined net borrowings of the Central and State governments in 2008-09 were nearly two and a half times the net borrowings in 2007-08 and these are budgeted to go up further by 34 per cent in 2009-10. Managing such a large borrowing programme in a non-disruptive way requires a nuanced approach to liquidity management.
Outlook on inflation
Among other strategies, the RBI has said that nearly 63 per cent of the Rs. 2,65,911 crore estimated net borrowings of the Central government will be completed by July. This will give it sufficient headroom to manage the remainder of the programme during the rest of the year. Also, the central bank has indicated its intention to purchase government securities under open market operations (OMO) for Rs. 80,000 crore during the first half.
The other obstacle to a softer monetary policy arises from the outlook on inflation. That the WPI inflation has been in negative territory since June does not matter. The decline is due to the statistical phenomenon of a high base effect and cannot be attributed to demand contraction. The base effect will wear off by September-October. The sharp fall in WPI inflation has been matched by a similar fall in inflation expectations.
Besides, consumer price inflation has remained persistently high due to costlier food articles, which uncertain and erratic monsoons will accentuate.
Global commodity prices are on a rebound ahead of a recovery. For these reasons, the RBI has hiked its WPI inflation target for end March 2010 to 5 per cent, one percentage point higher than projected in the April policy statement.
Growth prospects
According to the RBI, the outlook on growth has improved albeit marginally since April. The new projection for 2009-10 at 6 per cent with an upward bias is a slight improvement over the growth expectation of around 6 per cent indicated in the annual policy statement.
The overall macroeconomic scenario however continues to be uncertain and on balance an uptrend in the growth momentum is unlikely before the middle of 2009-10.
Keeping in view the high government borrowing programme, the projection for money supply for 2009-10 has been increased to 18 per cent from the 17 per cent in April. Deposits and non-food credit are projected to grow by 19 and 20 per cent.
Monetary stance
The stance of monetary policy for the remainder of the year is based on an overall assessment of inflation, growth and the fiscal situation. Its main components are:
(1) Maintain liquidity actively so that the credit demand of the government is met while ensuring flow of credit to the private sector at viable rates.
(2) Keep a vigil on the trends and signals of inflation and be prepared to respond quickly and effectively through policy adjustments.
(3) Maintain a monetary and interest rate regime consistent with price stability and financial stability supportive of returning the economy to the high growth path.
Finally, the big question: How long will the RBI persist with its expansionary policy? According to the review, it will persist with the present stance until there are definite and robust signs of recovery. But the policy will be dynamic. At some critical stage in the future the RBI will have to reverse course to anchor inflation expectations and subdue inflationary pressures while simultaneously preserving the growth momentum.
C. R. L. NARASIMHAN
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