Second Quarter Review of Monetary Policy 2009-2010
-Announced on the 27th October 2009
Part A. Monetary Policy
II. Stance of Monetary Policy
73. There has been a discernible improvement in the global economic outlook since the First Quarter Review in July 2009. In India too, there are definitive indications of the economy reverting to the growth track. Accordingly, attention around the world, as also in India, has shifted from managing the crisis to managing the recovery.
74. The policy dilemma for India is different in some important respects from that of advanced economies as also other emerging market economies. First, most of these countries do not face an immediate risk of inflation. Indeed, in several advanced economies, the concerns were about a possible deflation, which are just about waning. On the other hand, India is actively confronted with an upturn in inflation – a rising WPI inflation and stubbornly elevated CPI inflation.
75. Second, advanced economies are faced with households, firms and financial institutions still struggling with their impaired balance sheets. Fortunately, we do not have this problem in India, but we still have the challenge of reviving domestic consumption and investment demand, the traditional, dominant drivers of our growth.
76. Third, somewhat related to the point above, India has traditionally been a supply constrained economy in contrast to advanced economies which are demand starved. We need, in particular, to expand the supply of infrastructure – power, roads, urban infrastructure and social infrastructure. The supply constraints which remained subdued during the crisis period owing to weak demand, will re-emerge and may indeed become binding.
77. Fourth and importantly, India is one of the few large emerging economies with twin deficits – fiscal and current account deficits. While our current account deficit is modest, and may even be benign given the investment requirements of the economy, there can be no two views about the need to make a responsible, credible and time-bound fiscal adjustment. The arguments for fiscal consolidation and rectitude are compelling and widely known, and need not be repeated here. But an issue of some immediate relevance is the critical need to downsize the government borrowing programme so as to help sustain a moderate interest rate regime. This is crucial for investment demand to pick up on which hinge our long-term economic prospects.
78. Around the world, there is an active, and at times animated debate on the timing and sequencing of exit from the expansionary monetary stance. ‘Exit’ is a central issue in our policy matrix too. As the Reserve Bank has indicated in several public statements, our current monetary stance is not the steady state and we need to reverse the expansionary stance. It is important to recognise though that the exit debate in India is qualitatively different from that in other advanced and emerging economies because of the unique features of our macroeconomic context indicated above.
79. The precise challenge for the Reserve Bank is to support the recovery process without compromising on price stability. This calls for a careful management of trade-offs. Growth drivers warrant a delayed exit, while inflation concerns call for an early exit. Premature exit will derail the fragile growth, but a delayed exit can potentially engender inflation expectations.
80. The Reserve Bank has consulted a wide array of stakeholders in the run up to this policy review. Based on these consultations, the arguments for and against reversal of the expansionary monetary policy stance can be summarised as follows.
Arguments for Beginning Reversal of Monetary Easing
81. The most dominant argument for reversing monetary policy easing stems from the concern about inflation. WPI inflation has turned positive, the base effect which has kept WPI low so far is now gone and CPI inflation has remained stubbornly elevated. On a financial year basis, WPI has already increased by 5.95 per cent. Inasmuch as monetary policy acts with a lag, there is need to act now.
82. It is further argued that even though the current inflationary pressures are driven by food prices, they can strengthen expectations of higher inflation and lead to generalised inflation. The Reserve Bank’s inflation expectations survey shows that households expect inflation to increase over the next three months as also one year. The lag with which monetary policy operates suggests that there is a case for tightening sooner rather than later.
83. Forceful arguments for early reversal of monetary policy also arise from liquidity concerns. The LAF window has been absorbing over Rs.100,000 crore on a daily basis since May 2009, save for a few days on account of temporary increases in government balances. This evidences the large amount of liquidity in the system which could potentially result in an unsustainable asset price build-up. There is already some evidence of excess liquidity feeding through asset prices with potential financial stability concerns. Further, capital flows have resumed. Given the limitations of the economy’s current absorptive capacity, these flows will add to the overall domestic liquidity, further fuelling the asset price build-up. Large capital inflows and asset price inflation have the potential to feed on each other. From the liquidity dimension, it is further argued that the current large overhang of liquidity could engender inflation expectation even if credit demand remains subdued.
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