Mumbai: The Reserve Bank of India (RBI) will persist with actions aimed at reducing inflationary pressures, the central bank said in its review of the economy, setting the stage for a rate increase and a hawkish tone in the third quarter monetary policy due on Tuesday.
Factors underlying the inflation process pose a major challenge, the central bank said in its macroeconomic and monetary developments for the third quarter, published on the eve of the policy review.
“The anti-inflationary focus of monetary policy would have to continue, recognizing though the limits of monetary policy in dealing with structural pressures on inflation, and the need for forward looking response to demand-side pressures,” the central bank said.
An interest rate increase makes money costly and slows inflation, which accelerated at 8.43% in December on a year-on-year basis. While economists expect the inflation rate to drop in the coming months, RBI’s tenor implies that it does not want to take any chances. The number of references to inflation is perhaps the most in any of the recent macroeconomic reviews.
The central bank is also concerned that unchecked inflation may erode growth.
“While growth concerns have receded considerably, this is probably the first time that RBI is emphasizing so clearly that inflation could dent the growth process,” said Deepali Bhargava, economist at ING Vysya Bank Ltd.
RBI has raised its policy rates six times since March 2010. The repo rate, at which it injects liquidity into the system, stands at 6.25%, while the reverse repo rate rate, at which it drains liquidity, now stands at 5.25%.
The focus on containing inflation is in line with recent comments by central bank officials expressing concerns on the issue at various forums.
“Since a lower inflation regime is essential for sustainable high growth, containing inflation becomes the dominant policy objective in the current environment,” said the report, which was made public after the market closed on Monday.
Monetary policy would have to be guided not just by the anti-inflationary thrust necessary in an environment of persistent high prices, but also its expected effectiveness amid entrenched supply-side pressures.
Benchmark nine-year government bonds fell for a second day, on speculation the central bank will raise interest rates on Tuesday. The yield rose one basis point to 8.17%. The benchmark index of the Bombay Stock Exchange, the Sensex, which has declined 6.6% this year, gained 0.8%. The rupee slipped 0.1% to 45.68 against the dollar.
The spurt in food prices in December was driven by factors that “were largely unanticipated”, RBI said. It has already recognized the upside risks to inflation from higher global commodity prices, “but this hardening happened sooner than anticipated”.
The expected decline in food prices after a normal monsoon did not materialize, reflecting the impact of growing structural imbalances in certain sectors, particularly non-cereal food items.
“The factors underlying the inflation process pose a major challenge for monetary policy since the impact of anti-inflationary monetary policy measures on inflation expectations and core inflation could be weakened considerably by structural factors, particularly in an environment of firming global commodity prices,” RBI said.
Along with the supply-side pressure, emanating from the firming up of global commodity prices, RBI is also concerned about inflation engendered by demand-side dynamics.
Despite the hawkish language, most economists expect RBI to make a modest 0.25% increase in deposit rates.
“In 2005-08, when the economy was growing at 9.5%, inflation was growing at 6%. Even as inflation is at an elevated level now, growth sustaining at the 2005-08 level is unlikely. Credit is going to be very expensive this year. A steeper rate hike is unlikely despite the inflation concerns,” said Bhargava.
Credit in the banking system has been brisk, at 24.4% so far in December, against RBI’s expectation of 20%. However, deposits grew slower at 16.5% year-on-year, forcing banks to access funds at a higher rate and making credit costly.
The RBI report discusses for the first time the effect of the Mahatma Gandhi National Rural Employment Guarantee Scheme. The guaranteed income generated by this has the potential to raise the bargaining power of the unorganized sector, particularly in the agriculture and construction industries, besides raising rural demand at a faster pace relative to the production of cereals and non-cereal food items, RBI said.
The demand-side pressure is also visible in the growing size of the current account deficit, which is now reigning at more than 3% of gross domestic product (GDP). While there are enough stocks to provide security, this doesn’t ease pressure on food inflation, RBI said. The items driving the measure upwards are outside the ambit of food security, it added.
The report card was, however, buoyant on growth prospects. In fact, the survey of professional forecasters said the economy will grow at 8.7% in fiscal 2011 against 8.5% reported in the previous survey, even as the report cautioned that manufacturing sector growth is yet to become broad-based.
GDP expanded at 8.9% in the first half of 2010-11, making it the fastest growing major economy in the world after China.
However, in order to sustain growth momentum, “risks to inflation from structural imbalances need priority attention”, RBI said, adding that growth is “expected to coexist with elevated inflation in the near term”.
RBI said while government expenditure is expected to resume, easing the liquidity pressure on banks, the system would still have to continue with a deficit equivalent to 1% of the deposit base. This roughly translates to around Rs 50,000 crore, it said.
This liquidity pressure makes the transmission of monetary policy more effective, RBI said.
Bloomberg contributed to this story.