Important developments have taken place in recent weeks with regard to
inflation. To assess these developments, it is important to recognise the
key forces at work. The escalation in inflation last week mainly reflects
the pass-through of international crude prices to domestic prices effected
on June 5, 2008. Unlike in some mature economies, however, the pass-through
is not occurring on a continuous basis in developing economies including
India. Thus, the policy response to the escalation in crude prices could be
somewhat similar to other countries but tailored to suit our conditions.
Besides oil prices, there are some underlying inflationary pressures
impacting inflation in India. Inflation, based on variations in the
wholesale price index (WPI) on a year-on-year basis, increased to 11.05 per
cent as on June 7, 2008 from 7.75 per cent at end-March 2008 and 4.28 per
cent a year ago. Excluding the fuel sub-group, inflation rose to 9.61 per
cent from 5.92 per cent a year ago. Excluding fuel and food, inflation was
10.33 per cent as against 6.33 per cent in the corresponding period of the
preceding year. inflation based on the consumer price index (CPI) for
industrial workers (IW) and urban non-manual employees (UNME) stood at 7.81
per cent and 6.99 per cent, respectively, on a year-on-year basis in April
2008 as compared with 6.67 per cent and 7.74 per cent a year ago. Inflation
based on CPI for agricultural labourers (AL) and rural labourers (RL) stood
at 9.11 per cent and 8.84 per cent in May 2008, respectively, as compared
with 8.22 per cent and 7.90 per cent a year ago. Therefore, it is important
to recognise that an adjustment of overall aggregate demand on an
economy-wide basis is warranted to ensure that generalised instability does
not develop and erodes the hard-earned gains in terms of both outcomes of
and positive sentiments on India's growth momentum.
The urgency of this broader, *albeit* somewhat painful but timely
contraction has to be viewed in the context of the new reality of high and
volatile energy prices not necessarily being a temporary phenomenon any
longer. Monetary policy recognises the need to smoothen and enable this
adjustment so that inflation expectations are contained. The Reserve Bank
has been acting pre-emptively from April 2008 onwards, keeping in view the
lagged effects of such measures on the economy. Accordingly, the cash
reserve ratio (CRR) was raised by 25 basis points each from the fortnights
beginning April 26, May 10 and May 24, 2008. On May 30, 2008 special market
operations were announced to alleviate the binding financing constraints
faced by public oil companies in importing POL as also to minimise the
potential adverse consequences for financial markets in which these oil
companies are important participants. Subsequent to the announcement of the
oil price hike, the repo rate was increased by 25 basis points on June 11,
2008.
This calibrated approach on an ongoing basis and in a timely manner draws
upon the lessons from managing these challenges in the recent period.
Graduated monetary policy actions undertaken since September 2004 to
withdraw monetary accommodation have successfully moderated signs of
overheating that emerged in 2006-07 and continue to have some stabilising
influence on the economy. Supply management strategies undertaken by the
Government of India are also working through the economy.
However, on a year-on-year basis, money supply (M3) increased by 21.4 per
cent as on June 6, 2008 over and above the growth of 21.0 per cent a year
ago and well above the indicative projection of 16.5-17.0 per cent set for
2008-09 in the Annual Policy Statement of April 2008. Similarly, reserve
money increased by 28.5 per cent on June 13, 2008 as compared with 24.6 per
cent a year ago. Aggregate deposits rose by 23.2 per cent on a year-on-year
basis on June 6, 2008 which is above the indicative projection of 17.0 per
cent for 2008-09. Non-food credit growth was 26.2 per cent and was also
above the indicative projection of 20.0 per cent.
At this juncture, the overriding priority for monetary policy is to eschew
any further intensification of inflationary pressures and to firmly anchor
inflation expectations. Several positive factors that currently exist need
to be recognised. Relative to several other emerging economies, the Indian
economy has, by and large, a reasonable supply-demand balance which provides
some insulation in managing this unprecedented shock from global oil
markets. Domestic financial markets and institutions have been largely
secured against the contagion from the unsettled conditions in international
financial markets. Furthermore, India is somewhat de-coupled from the
intensifying global food crisis in view of the improvement in domestic
agricultural performance. The external sector is strong and resilient with
modest current account deficits relative to the size of the economy and has
a comfortable level of foreign exchange reserves. Accordingly, the major
focus of public policy at the current juncture needs to be on dealing with
the impact of the escalation of international crude prices in a well-managed
and smooth adjustment that draws on demonstrated strengths and positive
outcomes. Moderating and managing aggregate demand so that pressures on
prices are not intensified is a critical element of this approach.
In this regard, monetary policy has to urgently address aggregate demand
pressures which appear to be strongly in evidence. First, inflation has
increased to a 13-year high and inflation expectations have been driven up
by unrelenting pressures from international commodity prices, particularly
crude and metals. Second, investment demand continues to be strong, growing
in the range of 14-19 per cent annually since 2002-03 and currently
constituting 36 per cent of GDP. This is also reflected in the pick-up in
the growth of domestic capital goods production in April 2008 after some
deceleration in January-March. Furthermore, consumption demand appears to be
reviving the production of consumer goods, with a turnaround in the
production of durables. Third, with merchandise imports running ahead of
exports, the trade deficit widened sizeably in 2007-08 and has continued to
expand in April 2008. Although large oil imports appear to be the main
driver, non-oil imports have also increased at a considerable pace,
contributing more than 60 per cent of the overall import growth in April
2008 and reflecting the pressure of domestic demand. There has also been
some tightening of external financing conditions in the ongoing global
financial turmoil. Fourth, fiscal pressures are emerging due to the
possibility of enhanced subsidies on account of food, fertiliser and POL as
well as for financing deferred liabilities relating to farm loan waivers
with implications for additional pressures on aggregate demand, and with
potential spillovers into the external sector.
The overall stance of monetary policy in 2008-09 was set in terms of
ensuring a monetary and interest rate environment that accords high priority
to price stability, well-anchored inflation expectations and orderly
conditions in financial markets while being conducive to continuation of the
growth momentum with due emphasis on credit quality and credit delivery. It
was resolved to respond swiftly on a continuing basis to the evolving
constellation of adverse international developments and to the domestic
situation impinging on inflation expectations, financial stability and
growth momentum, with both conventional and unconventional measures, as
appropriate.
Consistent with the stance of monetary policy as set out above and on the
basis of incoming information on domestic and global macroeconomic and
financial developments, it has been decided to take the following measures:
(a) The repo rate under the Liquidity Adjustment Facility (LAF) is increased
from 8.00 per cent to 8.50 per cent with immediate effect.
(b) The cash reserve ratio (CRR) of the scheduled commercial banks, regional
rural banks (RRBs), scheduled state co-operative banks and scheduled primary
(urban) co-operative banks is being increased by 50 basis points to 8.75 per
cent in two stages, effective from specified fortnights as indicated below:
Effective date
(i.e., the fortnight beginning from)
CRR on net demand and time liabilities
(per cent)
July 5, 2008
July 19, 2008
8.50
8.75
In view of the criticality of anchoring inflation expectations, a continuous
heightened vigil over ensuing monetary and macroeconomic developments is
warranted to enable swift responses with appropriate measures as necessary,
consistent with the monetary policy stance.
*Alpana Killawala
*Chief General Manager
*
Press Release : 2007-2008/1649
*
*.http://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=18491*
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