First Quarter Review of Annual Monetary Policy for 2008-09
II. Stance of Monetary Policy for the
Period of 2008-09
86. The Annual Policy Statement of April 2008 had indicated concerns that threats to growth and stability from global developments had increased considerably with a highly uncertain likelihood of early resolution. However, it was stated that domestic factors would continue to dominate the policy setting, with a contextual emphasis on inflation expectations. Accordingly, the overall stance of monetary policy in 2008-09 was set in terms of ensuring a monetary and interest rate environment that accords high priority to price stability, well-anchored inflation expectations and orderly conditions in financial markets while being conducive to continuation of the growth momentum with due emphasis on credit quality and credit delivery. It was resolved to respond swiftly on a continuing basis to the evolving constellation of adverse international developments and to the domestic situation impinging on inflation expectations, financial stability and growth momentum, with both conventional and unconventional measures, as appropriate.Liquidity management was accorded priority in the context of underlying monetary and financial developments.
87. In the subsequent period, active liquidity management assumed critical importance in view of persistent surplus conditions in financial markets coinciding with an upsurge in inflation.Accordingly, the CRR was raised on April 17, 2008 by 25 basis points each from the fortnights beginning April 26 and May 10, 2008. Subsequently, another increase of 25 basis points in the CRR effective from May 24, 2008 was announced in the Annual Policy Statement. On May 30, 2008 special market operations were announced to alleviate the binding financing constraints faced by public oil companies in importing POL as also to minimise the potential adverse consequences for financial markets in which these oil companies are important participants. Subsequent to the announcement of the hike in administered POL prices, the repo rate was increased by 25 basis points on June 11, 2008.Furthermore, on June 24, the repo rate was increased by 50 basis points and the CRR was increased by 25 basis points each from the fortnights beginning July 5 and July 19.These measures, along with the calibrated and graduated withdrawal of monetary accommodation undertaken since September 2004, impart a stabilising influence on the economy in the period ahead.In view of the criticality of anchoring inflation expectations, a continuous heightened vigil over ensuing monetary and macroeconomic developments is maintained to enable swift responses with appropriate measures as necessary, consistent with the monetary policy stance.
88. Monsoon conditions have, by and large, been favourable so far in large parts of the country barring deficient/scanty rainfall in some regions that could affect the prospects of some crops. Nevertheless, in the absence of unanticipated weather adversities, moisture conditions should support a continuation of the above medium-term trend growth in agriculture. On the other hand, there is more than originally anticipated moderation in activity in the industrial and in some services sectors. Such a moderation could persist in the short-term, notwithstanding the still robust underlying momentum in these sectors.Furthermore, world GDP growth is projected by the IMF to undergo a pronounced slowdown in the second half of the year and is expected to decelerate by close to one percentage point in relation to 2007 with second round effects on world trade growth.Overall, taking into account aggregate demand management and supply prospects described above, the projection of real GDP growth of the Indian economy in 2008-09 in the range of 8.0 to 8.5 per cent as set out in the Annual Policy Statement of April 2008 may prove to be optimistic and hence for policy purposes, a projection of around 8.0 per cent appears a more realistic central scenario at this juncture, barring domestic or external shocks.
89. Bringing down inflation from the current high levels and stabilising inflation expectations assumes the highest priority in the stance of monetary policy.Currently, pressures from global inflation developments emanate from prices of some food articles, crude oil and other commodities such as metals. As regards food prices, there are indications of improvement in crop conditions in some of the major foodgrains producing countries.For the Indian economy, monsoon conditions augur well for an expansion of the domestic supply response, particularly in respect of key foodgrains. In this context, domestic food prices may soften in the months ahead as these positive developments take hold.International crude prices remain at elevated levels with no clear indication of any tendency towards assured moderation, despite some incipient softening in recent weeks.There is, however, a view that slowdown in global activity may moderate demand and speculative elements.Accordingly, there is a possibility, albeit remote, of a drastic reduction in the level of crude prices in the period ahead.In the event, however unlikely, of international crude prices falling below the level up to which pass-through to domestic POL prices in India has occurred, therecould be some easing of domestic inflation. There is also a view that international prices of other commodities including metals could also moderate with the slowing down of aggregate demand globally. While such moderation in some global commodity prices in future cannot be ruled out, it is prudent to assume that in all likelihood, the current elevated levels will continue in the near future with added uncertainties.
90. The Annual Policy Statement of April 2008 stated that, in view of the lagged and cumulative effects of monetary policy on aggregate demand and assuming that supply management would be conducive, capital flows would be managed actively and in the absence of new adversities emanating in the domestic or global economy, the policy endeavour would be to bring down inflation from the current high to around 5.0 to 5.5 per cent in 2008-09 with a preference for bringing it as close to 5.0 per cent as soon as possible, recognising the evolving complexities in globally transmitted inflation. The Annual Policy Statement added that the resolve, going forward, would continue to be to condition policy and perceptions for inflation in the range of 4.0-4.5 per cent so that an inflation rate of around 3.0 per cent becomes a medium-term objective consistent with India's broader integration into the global economy and with the goal of maintaining self-accelerating growth over the medium-term. Recent developments, global as well as domestic, on both supply and demand sides described in this Policy Review, however, point to accentuation of inflationary pressures, especially in terms of inflation expectations and perceptions during the first quarter of 2008-09.
91. Over the last 12 months, the escalation in inflation has become a global phenomenon and the increase in inflation in India over the previous year is not proportionately different from elsewhere. Looking forward, the global and more importantly, the domestic factors pose severe challenges to monetary management and warrant reinforced policy actions on several fronts.Against this background, it is expected that inflation would moderate from the current high levels in the months to come and a noticeable decline in inflation can be expected towards the last quarter of 2008-09. Accordingly, while the policy actions would aim to bring down the current intolerable level of inflation to a tolerable level of below 5.0 per cent as soon as possible and around 3.0 per cent over the medium-term, at this juncture a realistic policy endeavour would be to bring down inflation from the current level of about 11.0-12.0 per cent to a level close to 7.0 per cent by March 31, 2009.
92. As indicated in the Annual Policy Statement of April 2008, the sustained expansion of money supply above indicative projections since 2005-06 has resulted in a sizeable monetary overhang which warrants continuous policy monitoring in view of the implications for fighting inflation at the current juncture and over the medium term as the lagged and cumulative effects of monetary policy actions work their way through the economy. Accordingly, it is necessary to moderate monetary expansion and plan for a rate of money supply growth in the range of around 17.0 per cent in 2008-09 in consonance with the outlook on growth and inflation so as to ensure macroeconomic and financial stability in the period ahead. Consistent with the projection of money supply, the growth in aggregate deposits in 2008-09 is now placed at around 17.5 per cent or around Rs.6,00,000 crore.Based on an overall assessment of the sources of funding and the overall credit requirements of the various productive sectors of the economy, the growth of non-food credit including investments in bonds/debentures/shares of public sector undertakings and private corporate sector and CP is placed at around 20.0 per cent in 2008-09, as indicated in the Annual Policy Statement, consistent with the monetary projections.While there are early signs of some moderation in money supply and deposit growth, they continue to expand above the indicative projections warranting continuous vigilance and appropriate and timely policy responses.
93. Active management of liquidity conditions through the flexible use of policy instruments has, to a significant extent, insulated domestic financial markets from the turmoil in major financial centres in developed economies.These liquidity management operations have generally absorbed excessive market pressures and enabled orderly conditions. In view of the evolving environment of heightened uncertainty, volatility in global markets and the dangers of potential spillovers to domestic equity and currency markets, liquidity management will continue to receive priority in the hierarchy of policy objectives over the period ahead.In particular, volatility in capital flows and cash balances of the Government will continue to necessitate active liquidity management with a combination of instruments as warranted. In this context, it is necessary to note that there is headroom with the Reserve Bank in terms of the flexibility in the deployment of instruments, complemented by prudential regulations and instruments for capital account management.
94. Since April 2005, the Reserve Bank has been expressing concerns about strong credit growth, the significantly overdrawn state of the banking system to sustain the credit disbursement, mismatches between sources and uses of funds and implications for interest rates, liquidity conditions and credit quality.Several monetary and prudential measures have been undertaken in this period and banks have been sensitised in this regard. While there has been some rebalancing and overall correction during 2007-08 in response to policy initiatives, in 2008-09 so far, however, some banks have expanded credit rapidly in relation to the system level growth, with attendant worsening of their credit-deposit ratios.These developments warrant heightened policy concerns in the interest of overall systemic stability and the quality of financial intermediation.In this context, banks are urged to review their business strategies so that they are in a position to combine longer term viable financing with profitability in operations, recognising the reality of business cycles and countercyclical monetary policy responses. A key aspect of this review should be a renewed emphasis on credit quality while simultaneously pursuing greater credit penetration and financial inclusion.Banks should focus on stricter credit appraisals on a sectoral basis, monitor loan to value ratios and generally ensure the health of credit portfolios on a durable basis without encountering undue asset-liability mismatches. If necessary, the Reserve Bank would consider undertaking supervisory review of those select banks which are over extended in terms of their credit portfolios relative to their sources of funds.
95. The impact of the escalation in international food, crude and other commodity prices is already being reflected in a sizeable expansion in the merchandise trade deficit and persisting downward pressures in the foreign exchange market.Furthermore, capital flows have exhibited some volatility with episodes of portfolio outflows and tightening of international bank lending.Overall, the merchandise trade deficit is expected to be somewhat higher and the current account deficit marginally higher in 2008-09 than in the preceding year. It is, however, expected that net capital flows would meet the external financing requirement in 2008-09.
96. Early fiscal indicators point to some strains on the Centre's fiscal position which has worsened somewhat in relation to budget estimates.In view of growing off-budget liabilities and enhanced expenditures on subsidies, loan waivers and salaries in the rest of the year, fiscal developments warrant close and careful monitoring in view of the configuration of risks both domestically and globally, and, in particular, the implications for inflation and external sector management. The evolving fiscal conditions in an atmosphere of persistent inflationary pressures pose severe challenges to monetary management, especially if supply inelasticities continue to prevail in the short-term.
97. As stated in the press release announcing monetary measures on June 24, 2008 and increasingly relevant at this juncture, the overriding priority for monetary policy is to eschew any further intensification of inflationary pressures and to firmly anchor inflation expectations. In this regard, monetary policy has to urgently address aggregate demand pressures which appear to be strongly in evidence. The Reserve Bank's approach in this regard is in a calm and calculated fashion avoiding exaggerated bearishness and on an ongoing basis, in a timely manner and conscious of strengths and challenges in this context. This measured monetary policy response has moderated early signs of overheating that emerged in 2006-07 and would continue to work in conjunction with supply-side measures to bring down inflation to more acceptable levels on an urgent basis by building on actions already taken. Therefore, it is important to recognise that in an environment of limited supply elasticities in the short run, an adjustment of overall aggregate demand on an economy-wide basis is warranted to ensure that generalised instability does not develop and erode the hard-earned gains in terms of both outcomes of and positive sentiments on India's growth momentum. In this specific context, the Reserve Bank's effort is to smoothen and enable this adjustment so that inflation expectations are contained.
98. Global growth has decelerated in the first quarter of 2008 and is expected to slow down further over the rest of the year as indicated in the waning business and consumer confidence and weak industrial activity. There are also indications that the slowdown is becoming more broad-based in advanced economies and incipiently in emerging economies as well.Threats to financial stability also continue to rule at elevated levels with possible feedback into the prospects for macroeconomic performance.Inflation pressures are likely to intensify further in both advanced and emerging economies, driven by the relentless rise in food and fuel prices and tightening supply constraints.Slower growth in demand may temper commodity prices and ultimately inflationary pressures; however, the manner and period over which this adjustment would take place is highly uncertain.Increasingly, it is felt that a multilateral effort is needed to ameliorate the social and economic deprivation associated with this shock, improve the supply-demand balance in commodity markets and fortify the national macroeconomic policy responses.
99. These global developments have implications for India's macroeconomic outlook with sharp challenges and dilemmas confronting the setting of monetary policy.First, it is necessary to recognise the global dimensions of the crisis which is threatening the credibility of monetary policy worldwide. Second, monetary policy has to deal with the structural components embedded in the drivers of inflation which, unlike cyclical elements, are somewhat impervious in the short run to instruments of aggregate demand management. Third, while modulation of aggregate demand assumes crucial importance, it is also necessary to nurture and consolidate the recent gains in augmenting supply capacities and improvements in productivity and efficiency which accrue over a longer term horizon. Fourth, even though concerns about the financial crisis deepening have retreated in recent weeks, financial markets are still fragile and impairment to balance sheets of financial institutions and credit conditions has increased the vulnerability to financial instability, further complicating the conduct of monetary policy.Against this backdrop, it is essential to stabilise and anchor inflation expectations as soon as feasible.
100. Accordingly, as stated in the Annual Policy Statement of April 2008, it is critical at this juncture to demonstrate on a continuing basis a determination to act decisively, effectively and swiftly to curb any signs of adverse developments in regard to inflation expectations. In view of the above unprecedented uncertainties and dilemmas, it is important to take informed judgements with regard to the timing and magnitude of policy actions; and such judgements need to have the benefit of evaluation of incoming information on a continuous basis.
101. The Reserve Bank will continue with its policy of active demand management of liquidity through appropriate use of the CRR stipulations and open market operations (OMO) including the MSS and the LAF, using all the policy instruments at its disposal flexibly, as and when the situation warrants.
102. In sum, barring the emergence of any adverse and unexpected developments in various sectors of the economy, assuming that capital flows are effectively managed, and keeping in view the current assessment of the economy including the outlook for growth and inflation, the overall stance of monetary policy in 2008-09 will broadly continue to be:
To ensure a monetary and interest rate environment that accords high priority to price stability, well-anchored inflation expectations and orderly conditions in financial markets while being conducive to continuation of the growth momentum.
To respond swiftly on a continuing basis to the evolving constellation of adverse international developments and to the domestic situation impinging on inflation expectations, financial stability and growth momentum, with both conventional and unconventional measures, as appropriate.
To emphasise credit quality as well as credit delivery, in particular, for employment-intensive sectors, while pursuing financial inclusion.
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