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Business News/ Opinion / Online-views/  A new monetary policy structure
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A new monetary policy structure

Though RBI held repo rates at 8%, its policy stance remains hawkish as risks to inflation persist

On sticky core inflation, RBI notes that potential growth of the economy has come down, and the resultant negative output gap (or excess capacity) may actually be minimal at this stage. Photo: MintPremium
On sticky core inflation, RBI notes that potential growth of the economy has come down, and the resultant negative output gap (or excess capacity) may actually be minimal at this stage. Photo: Mint

Taking comfort from easing Consumer Price Index (CPI) inflation and moderating inflation expectations of households, the Reserve Bank of India (RBI) kept the repo rate unchanged at 8%. This was along the expected lines, as retail inflation continues to move along the trajectory indicated by the central bank in its January policy announcement. The policy stance, however, remains cautiously hawkish as risks to inflation persist.

Concerns on inflation emanate from the fact that the recent disinflation is largely due to easing food prices, in particular vegetable prices, while core inflation that excludes food and fuel remains high and sticky at 8%.

Moreover, upward risks to inflation, especially those originating from domestic factors, remain strong. Here the likelihood of a poor monsoon this year and the subsequent upward pressure on food prices remains a key risk. To add to that the uncertainty in the setting of minimum support prices of farm produce and prices of fuel, power and fertilizer, heightens the risks around the achievement of 8% headline CPI inflation by January 2015.

The ongoing tapering by the US Federal Reserve poses a risk too, as it can trigger volatility in capital inflows, especially if the pace of tapering picks up, and put pressure on the currency. Failure to form a stable government at the Centre is another risk the RBI is mindful of, as that too can trigger capital outflows and downward pressure on the rupee, heightening imported inflationary pressures.

On sticky core inflation, the RBI notes that the potential growth of the economy has come down, and the resultant negative output gap (or excess capacity) may actually be minimal at this stage. And, with some uptick expected in real gross domestic product (GDP) growth in fiscal year 2014-15 to 5.5%, core inflation could remain sticky, as the negative gap closes. That indeed may be the case, even as headline CPI inflation could ease at a brisk pace between June and November, due to high statistical base effect.

The RBI also continues to adopt the essential elements of a new monetary policy framework recommended by the Urjit Patel committee. Bringing headline CPI inflation down to 8% by January 2015 and further to 6% by January 2016 is now the guiding path which would determine the future course of policy action. This was the glide path recommended by the committee and the RBI has explicitly incorporated it in providing guidance on the future course of its monetary policy action. Hence the continuation of the current status quo is contingent upon headline inflation moving along this path. Given the upside risks, any sustained spike in inflation could push the RBI to tighten the policy further. And, the RBI would ignore the base effect induced-easing in CPI inflation, possible later this year.

Another key recommendation on the development of the term repo market and restricting bank’s access to overnight liquidity from the RBI, in order to enhance the monetary transmission mechanism, has also been adopted. Banks’ access to overnight liquidity through the liquidity adjustment facility (LAF) window has been further curtailed to 0.25% of their net demand and time liabilities while increasing the access to liquidity under 7- and 14-day term repos to 0.75% from 0.5%. While this measure is in the right spirit, it may have limited impact in terms of developing a term repo market, especially under the current deficit liquidity conditions.

The RBI has also sounded caution on the quality of the fiscal consolidation, while noting the success in mitigating external vulnerability through the reduction in the current account deficit. The central bank is rightly concerned that one-off non-tax receipts (spectrum auctions and special dividends by public sector companies) and overshooting of subsidies vis-à-vis budget estimates, do not make for a sustainable reduction in the fiscal deficit. Improving the quality of fiscal consolidation calls for reduction in subsidies with appropriate targeting.

Through this policy announcement, the RBI has managed to establish a structure around the future course of monetary policy. This would prove helpful in curtailing inflation expectations and support growth gradually.

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Published: 02 Apr 2014, 12:31 AM IST
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