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Daily News RBI Credit Policies (1999-2005)
Assessment of Macroeconomic and Monetary Developments during the First Half of 2005-06
Developments in the Global Economy
34. Global economic activity slackened in the second quarter of 2005, stalled by weak growth in the Euro area and Japan though domestic demand was sustained in the US. In emerging Asia - led by China and India - as well as in several developing countries in Latin America, the Middle East and Russia, growth has been robust. High and volatile international crude prices, global macroeconomic imbalances, international currency movements and the increasingly divergent growth profiles across regions have dampened the prospects for global recovery which had firmed up in the first half of 2004 and in the first quarter of 2005. The International Monetary Fund (IMF) expects global output growth to slow down, albeit moderately, to 4.3 per cent in 2005 from 5.1 per cent in 2004.
35. Elevated levels of international crude prices have driven up consumer price inflation in most of the advanced economies in the third quarter of 2005 though it has remained stable in Japan. Inflation has also risen in major emerging market economies and other developing countries. In emerging Asia, consumer price inflation has edged up in almost all countries except China. The hardening of energy, metals and minerals prices seems to have imparted some upward push to inflation. The rise in oil prices has triggered fears of generalised inflationary pressures globally.
36. Oil prices remain the single largest risk to the global economy, exacerbated by the continued increase in global demand, geopolitical uncertainties, strong refining demand and a series of supply disruptions. Worldwide petroleum demand growth is projected to remain strong during 2005 and 2006 and tepid production growth is expected in non-OPEC countries, leaving spare production capacity at its lowest level in three decades. Though there has been build-up in inventory levels in the OECD countries in the first half of 2005, demand has grown rapidly as well. A large component of the oil price increase is now being reckoned as permanent which needs to be eventually passed on to the consumers in the medium-term. Governments in some countries have tried to partially insulate their economies from rising oil prices by subsidising the use of energy. A cut in the subsidy in the future, while being desirable, could lead to significant increase in domestic inflation and higher interest rates in the short-term.
37. Risks to global growth also emanate from the persisting macroeconomic imbalances and the resulting abundance of global liquidity which carries the potential of fuelling asset bubbles, excessive leveraging in financial markets and threats to global financial stability. The current configuration of good growth, low inflation, abundant liquidity, flat yield curves, lowering of credit risk premia and ever-expanding search for yields has also benefited many emerging market economies which have strengthened their macro-fundamentals in an environment of low inflation, improved fiscal positions and balance of payments and substantial accumulation of foreign exchange reserves. On the downside, the same combination of factors has allowed the macro imbalances to widen and has resulted in a build-up of large volumes of debt, especially by the household sector. This has amplified the potential for sudden shifts in portfolios, investor preferences and currency alignments. The addition to global saving as a result of the increase in surpluses of oil exporters has enabled persistence of under-pricing of risks and a diffusion of risks across sectors. These factors have imparted an apparent stability to the financial system while sowing seeds of potential disequilibrium that might require a larger adjustment at a later stage. In the light of these developments, available evidence indicates that global imbalances have not really unwound but on the contrary, have perhaps worsened and amplified the surrounding uncertainties and risks.
38. Of the major central banks, the US Fed has raised its policy rate by 25 basis points each on eleven occasions from 1.0 per cent in June 2004 to 3.75 per cent by September 2005 while providing clear indications of a measured rise in the policy rate in the near term. The Bank of England has reduced its repo rate to 4.50 per cent in August 2005 in response to slowing domestic growth, after holding it steady at 4.75 per cent since August 2004. The European Central Bank (ECB) has kept its policy rate unchanged at 2.0 per cent since June 2003. Monetary policy has been tightened in several economies in emerging Asia, primarily in response to higher fuel prices. The indications in policy debates are towards either tightening or withdrawal of the accommodative stance.
39. The state of flux characterising global macroeconomic and financial conditions has confronted the conduct of monetary policy in various parts of the world with a similar spectrum of uncertainties and shifts therein. In fact, policy decision making in all countries has had to contend with difficulties of distinguishing news from noise in monitoring variables that are used to gauge the state of economic activity and the evolution of financial markets. This has made the dilemmas facing monetary policy sharper and policy errors costlier than before. In turn, this has brought about considerable cross-fertilisation and convergence in policy settings, choice of instruments and communication strategies. For monetary authorities vested with multiple objectives, the challenge is to continually rebalance the weights assigned to each, from as informed a judgment call as is feasible, given the prevailing uncertainties. Considerations of financial stability have, in particular, become a distinct dimension in the conventional trade-off between growth and price stability. Superimposed upon these overarching issues are country-specific factors which warrant tailored policy responses. For India, the linkages with the rest of the world in the context of the growing integration with the global economy are getting stronger and accordingly, global developments are becoming increasingly significant. Nevertheless, the evolution of domestic conditions of high growth with price stability, stable and vibrant financial markets and institutions, comfortable foreign exchange reserves and the entrenchment of democratic processes provide room for flexible and timely responses to the evolving circumstances in an uncertain external environment.
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