Second Quarter Review of Monetary Policy 2010-11
-Announced on the 2nd November 2010
II. Outlook and Projections
28. In its latest World Economic Outlook, the IMF has projected global growth to slow down from 4.8 per cent in 2010 to 4.2 per cent in 2011. Various indicators of economic activity in advanced economies point to deceleration of growth in the second half of 2010 which could persist through the first half of 2011. The room to provide additional fiscal stimulus to support the growth process remains constrained due to debt sustainability issues in some major advanced economies. Reflecting global linkages, the slowdown in the global recovery will have an adverse impact on growth in EMEs, including India, especially through the trade channel.
29. Inflation in advanced economies in the short-term is expected to remain subdued due to the prevailing low levels of capacity utilisation and high unemployment rates. However, the recent upward movements in international commodity prices, despite prospects of slow global recovery, raise some concerns. Several EMEs are already facing inflationary pressures. Food, energy and metal prices, in particular, have seen significant increases. The upward risk to inflation, therefore, has increased for EMEs, both from rising domestic capacity utilisation and from global commodity price increases.
30. Taking into account the good performance of the agriculture sector, and a range of indicators of industrial production and service sector activity amidst the prevailing global macroeconomic scenario, the baseline projection of real GDP growth for 2010-11, for policy purposes, is retained at 8.5 per cent, as set out in the July 2010 review
31. The Reserve Bank’s growth projection for 2010-11 is consistent with the median growth forecast from its professional forecasters’ survey and other agencies.
32. Although the headline inflation has moderated in recent months, the current rate of inflation is still well above the comfort zone of the Reserve Bank. The Reserve Bank’s quarterly inflation expectation survey conducted during the first fortnight of September 2010 indicates that short-term household inflationary expectations have increased marginally. Further, notwithstanding some moderation, food price inflation has remained persistently elevated for over a year now, reflecting in part the structural demand-supply mismatches in several commodities - besides protein sources, oilseeds and vegetables also show this pattern. Given the changing consumption patterns and as yet inadequate supply response, food price inflation is becoming increasingly structural in nature. Further, even as non-food manufacturing inflation has indeed moderated, it still remains above its medium-term trend.
33. Going forward, the inflation outlook will be shaped by the following factors. First, it will depend as to how food price inflation evolves. Second, rising global commodity prices have become a cause for concern. Third, demand pressures arising from sustained growth amidst tightening capacity constraints will have an impact. On balance, inflation is expected to moderate from the present elevated level, reflecting in parts, some easing of supply constraints and concerted policy action.
34. In its July Review, the Reserve Bank made a baseline projection of WPI inflation for March 2011 of 6.0 per cent. This projection was based on the old series of WPI. As has been indicated, there is not much difference at the aggregate level in the medium-term inflation trend between the old and new series, but there are significant differences at the group levels. On the basis of currently available information and the fact that expected moderation in food price inflation has also not fully materialised, the baseline projection of WPI inflation for March 2011 has been placed at 5.5 per cent, which is equivalent to 6.0 per cent under the old series. Effectively, this means that the projection remains unchanged from that made in the July 2010 Review
35. The Reserve Bank will endeavour to achieve price stability and anchor inflation expectations. In pursuit of these objectives, the Reserve Bank will continue to evaluate an array of aggregate and disaggregated measures of inflation in the context of the evolving macroeconomic situation.
36. Notwithstanding the current inflation scenario, it is important to recognise that in the 2000s, the average headline inflation rate remained in the range of 5.0-5.5 per cent, down from its historical trend rate of about 7.5 per cent. A combination of factors played a role in this transformation. One of these was the commitment on the part of the monetary policy to keep inflation low and stable. This record is an important foundation for the credibility of monetary policy and, more generally, the broader inflation management framework. Against this backdrop, the conduct of monetary policy will continue to condition and contain perception of inflation in the range of 4.0-4.5 per cent. This will be in line with the medium-term objective of 3.0 per cent inflation consistent with India’s broader integration into the global economy.
37. While the year-on-year money supply (M3) growth at 15.2 per cent in early October 2010 was below the indicative projection of 17.0 per cent, non-food credit growth at 20.1 per cent was close to the indicative projection of 20.0 per cent. There are already some signs of pick-up in deposit and credit growth. It is expected that monetary aggregates will evolve along the projected trajectory indicated in the April policy statement. Accordingly, the M3 and non-food credit growth projections for 2010-11 have been retained at 17 per cent and 20 per cent, respectively. As always, these numbers are indicative projections and not targets.
38. The above macroeconomic and monetary projections are subject to a number of upside and downside risks. First, the main downside risk to growth emanates from the prospects of a prolonged slow and halting recovery process in advanced economies as evidenced by the recent indicators of global economic activity. Concerns are being expressed that the ongoing fiscal consolidation in the absence of revival of private demand might weigh on the recovery process. Should the global recovery falter, the growth performance of EMEs, including India which has remained robust so far, is likely to be adversely affected. While India’s exports as a percentage of GDP are relatively low compared to other major EMEs, a widespread slowdown in global trade cannot but have an impact on the manufacturing and service sectors.
39. Second, although overall inflation and non-food manufactured products inflation have moderated in the recent period, inflationary pressures remain which may accentuate for several reasons. Despite the fragile global recovery, international commodity prices have risen in recent months due to strong demand from EMEs and some financialisation of commodities due to large surplus global liquidity. Should there be further quantitative easing by advanced economies, it will pose a further risk to global commodity prices. Persistently high domestic food inflation points to the presence of some structural component, which will continue to weigh on the overall inflation. With the domestic capacity utilisation slowly approaching the pre-crisis peak in many industries, demand side pressures may accentuate. Going forward, therefore, the risks to inflation are largely on the upside.
40. Third, given the weak recovery in advanced economies, Japan has already resorted to further monetary easing through unsterilised intervention in the forex market. Some other advanced economies are in the process of resorting to another round of quantitative easing. Given that growth prospects in EMEs, including India, are much better, the surplus liquidity generated by central banks in advanced economies could flow into the EMEs. In fact, the expectation of further quantitative easing in advanced economies has already resulted in large capital inflows to EMEs. As a result, exchange rates have been appreciating and asset prices have been rising in EMEs. Excess global liquidity combined with the significant growth differential, interest rate differential and higher financial market returns in India vis-ŕ-vis the advanced economies might lead to intensification of capital flows to India. Although India needs capital flows to finance its widening current account deficit, large capital flows beyond the absorptive capacity of the economy could pose a major challenge for exchange rate and monetary management.
41. Fourth, India’s current account deficit has widened in the recent period due to slowing down of exports and invisibles on the one hand and rising imports on the back of strong rebound of the domestic economy on the other. Although the current account deficit has been easily financed by the rising capital flows so far, the widening of the current account deficit raises concerns given the uncertainty associated with international capital flows.
42. Fifth, asset prices in India, as in many other EMEs, have risen sharply. The equity market is close to its previous all-time peak level. Residential property prices in metropolitan cities have gone beyond the pre-crisis peak level. Gold prices are ruling at an all-time high level. Although the income levels of households and earnings of corporates in India have continued to rise, a sharp rise in asset prices in such a short time causes concern.
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