Competitive Exams: Current Affairs 2011: RBI Mid Quarter Review

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RBI Mid Quarter Review

A plethora of conflicting trends and signals made the Reserve Banks mid quarter review a complex affair. Two important macro economic data industrial production numbers for July and the Wholesale Price Index based inflation for August were released recently, just days ahead of the policy meet.

Both have a substantial influence on the monetary policy formulation. The Index of Industrial Production data for July confirmed the slowdown in economic growth. At 3.3 per cent, it is the slowest rate of growth in almost two years. Contraction in production of both capital and intermediate goods accounted for a substantial portion of the decline. Growth in manufacturing, which constitutes 75.5 per cent of the IIP, hit a 21 month low at 2.3 per cent in July, down from 10.8 per cent during the same month last year. Growth during April

July this year has averaged just 5.8 per cent.

The weak data prompted calls for a pause in monetary tightening. Industrial growth, especially manufacturing, is highly interest rate sensitive.

At another level, it is also suggested that the GDP growth projections for the current year need to be reworked. For instance, the Economic Advisory Council to the Prime Minister had pegged the industrial growth at 7.1 per cent for this fiscal, which would deliver economic growth of 8.2 per cent. The assumption was that agriculture would grow by 3 per cent and services by 10 per cent.

Of course, the biggest worry is inflation. Headline inflation as measured by the WPI rose to 9.78 per cent for August from 9.22 per cent a month ago. Core inflation (non food manufactured inflation) , which the RBI tracks carefully, rose to 7.8 per cent from 7.5 per cent. The RBIs target range for inflation at the end of this fiscal is 7 per cent.

So on the eve of its policy meet, the choice before the RBI was as stark as it could ever be. Should it raise the policy rates to douse inflation a course of action that seems to suggest itself automatically given the persistence of inflation? Or should it pay heed to several appeals, including from the highest levels of the government and pause?

The RBI had hiked the rates 11 times between March, 2010, and July, 2011. The repo rate on the eve of the policy meet was 8 per cent.

Complicating the decision making is the worsening sovereign debt crisis in Europe and the high unemployment amidst low growth in the US While the Indian financial sector is insulated from the European crisis, exports might see a demand contraction in these developed markets. But by far the biggest impact of the sovereign debt crisis is on global commodity prices, whose phenomenal upsurge in the recent past drove up inflation. Theoretically, the crisis in Europe should soften commodity prices. However, the fall in commodity prices, including those of petroleum, has been arrested. The unconventional methods adopted in the US to stimulate the economy through ultra soft monetary policies are bound to push up global commodity prices, by increasing liquidity.

Finally, the argument that the RBI should take into account the deceleration in the economy is valid only up to a point.

In the first quarter of the current year, the economy grew by 7.7 per cent only marginally lower than the 7.8 per cent growth of the previous quarter. That there is a deceleration is not in doubt but there is no danger of a collapse. The RBI itself has on more than one occasion made it clear that a portion of the growth momentum will have to be sacrificed as it pursues an anti inflationary policy.

On Friday, the RBI hiked the policy repo rate by 0.25 percentage point for the 12th time to 8.25 per cent. The reverse repo rate has consequently been fixed at 7.25 per cent and the marginal standing facility rate at 9.25 per cent.

In a brief crisp policy statement, the RBI has explained the rationale of its action. Global macroeconomic outlook has worsened since the RBIs quarterly review of July 26.

The sovereign debt crisis in Europe has worsened. The US economy is beset by high unemployment and weak growth. Indias exports, now on a high growth trajectory, are expected to falter in the face of weak demand from the developed countries. Since domestic demand is also weak, partly due to the monetary action, there could be a case for revising downwards the RBIs growth estimate for the current year. Recently, the rupee has depreciated sharply against the dollar.

The RBI attributes this to increased risk aversion. It remains to be seen as to how far capital inflows will be affected. Food prices have remained persistently high despite a satisfactory monsoon.

No longer can they be treated as a temporary phenomenon. There are structural factors both on the supply and demand side underpinning food inflation.

The RBI expects inflation to moderate towards the end of the year as past monetary actions work their way through the system.

Monetary policy operates with a lag. Hence, a premature withdrawal of monetary tightening will be counter productive and harden inflation expectations. The mid quarter policy statement does not give a clue as to when the monetary tightening will begin to be phased out. Evidently the central bank will wait for a reversal in the inflation trajectory. Global developments will, of course, play a part.

Courtesy: The Hindu and Times of India