Mid-Term Review of the Annual Policy Statement for 2006-07, RBI Credit Policy: Banknet India

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I. Assessment of Macroeconomic and Monetary Developments during the First Half of 2006-07

Developments in the Global Economy

35. The global economy, now in its fourth successive year of above-average growth, appears to have maintained the pace of its expansion in the third quarter of 2006 on top of accelerated growth in the first half of the year. The moderation in the US economy seems offset by stronger growth in other parts of the world. According to the World Economic Outlook of the International Monetary Fund (IMF) released in September 2006, global real GDP growth on a purchasing power parity basis is expected to pick up from 4.9 per cent in 2005 to 5.1 per cent in 2006 before easing back to 4.9 per cent in 2007. Based on market exchange rates, world real GDP growth is projected to accelerate from 3.4 per cent in 2005 to 3.8 per cent in 2006 before decelerating to 3.5 per cent in 2007.

36. In the US, real GDP growth was 1.6 per cent in the third quarter (July-September) as compared with 5.6 per cent and 2.6 per cent in the first and second quarters, respectively, mainly indicative of a downturn affecting residential investment and inventories along with an acceleration in imports. The cooling of the housing market was reflected in declines in housing starts as also in new and existing home sales and, more recently, a fall in median house prices for the first time since 1995. The Japanese economy has been experiencing a period of sustained expansion in recent months. There has also been a gradual improvement in conditions for growth in the euro area. Rapid growth appears to have continued in China (10.4 per cent in the third quarter) and India (8.9 per cent in the second quarter). The performance of the other Asian economies has remained firm. Growth has been buoyant in Russia and Latin America, too.

37. The strength of the global economy over recent years has been accompanied by upward pressure on commodity prices till the first half of 2006. Higher demand, shortages in production due to unfavourable weather conditions in the early part of 2006 and declining inventories have tightened the overall cereal and sugar supply-demand situation. World cereal production is projected to decline. Global wheat stocks are at their lowest level in 25 years owing to drought conditions in major producing areas. Higher agricultural product prices are expected to result in an increase of over 2 per cent in the world food import bill in 2006. Metal prices have ruled firm since 2004, rising by 45.5 per cent during the first nine months of 2006 on top of an increase of 36.2 per cent in 2005. In the wake of the slowdown in the US, prices of these commodities have undergone some correction in recent weeks. Industrial metal prices have tended to decline, but dwindling stockpiles and firm demand have provided resistance.

38. Crude oil prices, which increased from around US $ 60 per barrel at the start of the year to reach record highs above US $ 78 in July and August, eased in September and October due to large US fuel inventories, signs of slowing US economic growth, a calmer Atlantic hurricane season and forecasts of a mild winter. Petroleum product prices have also undergone some softening with Nymex gasoline futures down by a third. The International Energy Agency has revised down its forecast for growth in world oil demand for 2006 and increased its forecast for oil production for 2007. The West Texas Intermediate (WTI) crude oil spot price is projected to average around $ 66 per barrel in 2007. Gold prices have also witnessed a correction of about 18 per cent from a 26-year peak reached in the first half of 2006, due to a sharp fall in jewellery fabrication.

39. In the US, consumer prices declined from 4.1 per cent in July to 3.8 per cent in August and further to 2.1 per cent in September, 2006. In the Euro area, inflation declined from 2.5 per cent during May-June to 1.8 per cent in September. Consumer prices increased moderately in Japan, i.e., by 0.6 per cent in September. In the UK, though, inflation breached the Bank of England’s target of 2.0 per cent in May and rose from 2.4 per cent in July to 2.5 per cent in August before decelerating to 2.4 per cent in September.

40. Globally, financial markets have been re-pricing risks in the aftermath of the sharp decline in several asset markets in May-June including, in particular, emerging markets. There has been a resilient recovery in global equity markets with the Dow Jones Industrial Average having risen to an all-time high on October 25, 2006. Investor optimism seems to have returned to most equity markets across the world, more significantly, to the emerging markets. The US yield curve remains inverted, reflected in a fall in 10-year bond yields from 5.22 per cent in early July to 4.88 per cent on October 27, 2006. In the Eurozone, 10-year bond yields have fallen from 4.19 per cent in early July to 4.0 per cent, even though the European Central Bank (ECB) is widely expected to raise rates further before the end of the year. Japanese 10-year bond yields have declined from 1.97 per cent in early July to 1.70 per cent. The US dollar depreciated against most major currencies in July and August, but recovered to appreciate marginally by October. In credit markets, spreads on emerging-market and corporate debt, which had widened in May-June, narrowed to all-time lows in September, following several sovereign rating upgrades.

41. The pass-through of international crude prices to domestic retail prices has been varied across countries while inflation expectations have remained firm. These factors have been reflected in monetary policy responses. Most central banks have been increasing policy rates but there is, in some cases, evidence of a pause, notably in the US. The Federal Reserve, which had been increasing its target rate (by 25 basis points each on seventeen occasions from June, 2004 to 5.25 per cent by June, 2006), paused in August-October, 2006. Other central banks that have kept their policy rates steady since July include the Bank of Japan (uncollateralised overnight rate to 0.25 per cent in July, 2006 after maintaining a zero interest rate policy since 2001); the Bank of Canada (by 50 basis points in April-May, 2006 to 4.25 per cent); Bank Negara Malaysia (policy rate at 3.5 per cent since April, 2006); the Bank of Thailand (the 14-day repurchase rate at 5.00 per cent since June, 2006); the Monetary Authority of Singapore; and the Banco Central de Chile (benchmark lending rate raised to 5.25 per cent in July, 2006); the Banco de Mexico (benchmark overnight lending rate at 7.0 per cent since April, 2006). In Turkey, policy rates which were raised by 425–625 basis points in June-July, 2006 were kept unchanged subsequently.

42. The ECB raised its policy rates five times since December, 2005 by 25 basis points each to 3.25 per cent; the Bank of England (which had raised its policy rate in August, 2006 by 25 basis points to 4.75 per cent, for the first time since August, 2005); the Reserve Bank of Australia (by 25 basis points in August, 2006 to 6.0 per cent); the People’s Bank of China (lending rate raised by 0.27 percentage points to 6.12 per cent on August 18, 2006; required reserve ratio by 50 basis points on July 5 to 8.0 per cent and a further increase of 50 basis points effective from August 15, 2006); and the Bank of Korea (by 25 basis points to 4.50 per cent on August 10).

43. A few central banks have eased monetary policy in the recent period such as Bank Indonesia (reduced its policy rate from 12.50 per cent to 10.75 per cent on October 5, 2006); and the Banco Central do Brasil (cut Selic rate target gradually from September 2005 to 13.75 per cent by October 2006).