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Central bank moves closer towards a neutral stance

Central bank moves closer towards a neutral stance

It is unfortunate that 2009-10 has had very high rates of inflation for food. In large measure, this flowed from the very weak monsoon of 2009, compounded by floods in early October. The magnitude of negative expectations on the extent of output decline was much larger than what it turned out to be, and it generated strong inflationary forces. By the time it was realized that Indian agriculture had shown greater resilience than expected and that output shortfalls were smaller than initially feared, the damage had been done. The rising momentum on foodgrain prices ended in January and prices have eased since.

However, as the monetary policy statement correctly points out, non-food manufactured items have increasingly contributed to the headline rate. In fact, the contribution of manufactured goods, other than food items, to the headline rate has risen from 0.7 percentage points (of the total 8.1%) in December, to 4.7 percentage points (of the total 9.9%) in March. Thus, prices of manufactured products are moving up, reflecting the general improvement of economic conditions in the Indian economy. It is also reflective of the increase in commodity prices which is no longer restricted to the price of crude oil. It is also possible that domestic excess capacity in some industries has fallen as a result of deferment of capital expenditure during the crisis, and in the near term, this may become a more significant factor in raising the pricing power of domestic firms.

Thus, monetary policy must rapidly complete its transition to a neutral stance, which arguably may be defined as one that produces an overnight call money rate of between 4% and 5%. Clearly, there is still some way to go. As the RBI statement itself says, despite “the increase of 25 basis points each in the repo rate and the reverse repo rate, our real policy rates are still negative. With the recovery now firmly in place, we need to move in a calibrated manner in the direction of normalizing our policy instruments". Credit offtake and financing needs of government may have influenced the central bank’s decision to opt for only a marginal increase in CRR. In any case, excessive play in liquidity is not consistent with the objectives as laid out by RBI.

This factor assumes particular significance on account of the exceptionally easy monetary policy in the US, which is likely to continue for a year or two. These external easy monetary conditions have a bearing on us through the medium of higher commodity prices and the easier availability of loan capital. After all, monetary easing always inflates. If it cannot inflate the home economy, i.e., the US, because of structural factors that are not yet played out, it will inflate elsewhere. And that elsewhere is Asia, with economies that are all growing nicely.

We have every reason to believe that the Indian economy is moving towards a 9% growth trajectory, and will do better than 8% in 2010-11 (if the monsoon is normal). And as it does, inflationary pressures are likely to develop along the many seams of the economy, given that we remain a supply-constrained economy. The recent months with high rates of food inflation have seemingly displaced inflationary expectations upwards, with talk of 6% and 7% as being more “realistic". It has taken a long time and much effort for us to bring inflationary expectations down to 4–5%. All necessary steps must be taken such that “inflationary expectations will be anchored", in RBI’s words; or rather, re-anchored at 4–5%.

The author is member, Planning Commission.

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