RBI 3rd Quarter Monetary Policy Review 2010-11 – Containing inflation to remain predominant objective

The RBI monetary policy soap opera verdict is out. The mixed global recoveries rather still subdued and the inflationary pressures in emerging market economies (EMEs) including India has been on the top of the radar of RBI in its Third Quarter Monetary Policy Review 2010-11. From the earlier stance of growth-inflation dynamics, the RBI moved to anchor the inflationary expectations likely due to sharp increase in the prices of primary food articles and the recent spurt in global oil prices.

Key Policy Measures:

•  Repo rate, the rate at which banks borrow from RBI, up by 25 bps at 6.5 per cent
•  Reverse repo rate, the rate at which the RBI lends to banks, up by 25 bps at 5.5 per cent
•  Cash Reserve Ratio (CRR), the portion of deposit that banks keep with the central bank retained at 6.0 per cent
• The inflation target revised upwards to 7 per cent from 5.5 per cent for march-end 2011
• The baseline projection of real GDP growth retained at 8.5 per cent with an upward bias.

Domestic Outlook

The domestic economy is on strong trajectory path as revealed by the 8.9 per cent GDP growth in the first half of 2010-11 powered mainly by domestic factors including strong consumption. The strong agricultural output on satisfactory kharif production and higher rabi sowing will contribute significantly to overall GDP growth in 2010-11. The industrial output also showed buoyant figures; however, the significant volatility adds uncertainty to the outlook.

Inflationary Concerns

The headline inflation as measured by WPI remained uncomfortably high since Jan 2010. Although it moderated between Aug and Nov 2010, it reversed in Dec 2010 mainly due to sharp increase in prices of vegetables specially onion, tomatoes, garlic etc and petrol prices. The current inflation level is also contributed by structural demand-supply mismatches in other cereal items. Considering all the scenarios, the baseline projection of WPI inflation for March 2011 has been revised upwards to 7 per cent from 5.5 per cent earlier. The sources of price pressure – fuel and non-fuel commodity prices and some food items could be non-responsive to RBI monetary policy actions. Going forward, the price level will depend how the global and domestic prices evolve.

Liquidity – still in deficit mode

Since the outflows caused due to 3G and WIMAX payments, the liquidity remained in deficit mode in the financial system. Also, the sluggish deposit growth, far below the RBI projection along with the non-food credit growth of 24.4 per cent worsened the liquidity in the system. Meanwhile, the RBI also intervened by cutting SLR by 1 per cent and initiated OMO transactions worth Rs. 67,000 crore. The additional liquidity support to banks up to 1 per cent of NDTL has been extended up to April 08, 2011. Under this, the bank may seek waiver of penal interest purely as an ad hoc measure. The 2^nd LAF will be conducted on a daily basis up to April 08, 2011.

Burgeoning CAD (Current Account Deficits)

The current CAD expected to be around 3.5 per cent of GDP is not sustainable as feared by RBI. CAD, an outcome of net exports and imports may get worsened further if the global recovery improves. Till now, the capital flows, which so far have been broadly sufficient to finance CAD may get adversely affected as the global recovery can trigger the flight to safety.

Global Scenario

There has been a significant improvement in global growth prospects in recent weeks; however, the recoveries are still fragile with uneven scenarios in Euro region and Japan. The deflation fears looming largely on advanced economies got some reprieve with early signs of inflation. The real GDP growth in the US improved to 2.6 per cent in Q3 2010-11 after witnessing a muted growth in 1.7 per cent. The retail sales and corporate capital spending has improved. Unlike in advanced economies, Emerging Market Economies (EME) has been affected by burgeoning inflation trends due to spurt in global food prices including a spurt in crude oil. 

With better signs of sustainable recoveries, the global growth in 2010-11 is anticipated to be less frictional and will show firm signs of sustainable recoveries. With rising prices on increased demand, inflation would be a global concern in 2011.

Why the rate hikes?

The market had been anticipating a tougher stand from RBI as the inflationary issues failed to settle down. While the market had mixed anticipations – 25bps vs 50bps hike, the RBI followed a calibrated approach – hiking the policy rates by 25 bps only – after taking a “comma” stand for few weeks in its policy rate hikes. The current policy rate is still below the pre-crisis level. Since March 2010, it has increased rates by six times. Also, keeping the LAF corridor at 1 per cent, the RBI intended to bring down the volatility in overnight rates within the corridor.

Happy Reading!

-          Amar Ranu