Second Quarter Review of Monetary Policy 2009-2010
-Announced on the 27th October 2009
Part A. Monetary Policy
II. Stance of Monetary Policy
Arguments for Deferring Reversal of Monetary Easing
84. The dominant argument for continuing with the current monetary stance is that the recovery is as yet fragile. Exports are still on the decline and the recent improvement in industrial production overstates the recovery as part of it is due to the base effect and the one time impact of restocking inventory. Premature tightening will hurt the growth impulses. On the other hand, it is imperative to continue with the accommodative stance to compensate for the decline in agricultural output and till there is firm evidence of sustained global recovery.
85. The second argument against an immediate reversal of monetary easing is that the current inflationary pressures are driven by supply side constraints, particularly food prices. Monetary policy is typically not an efficient instrument for reining in food price inflation. There could, of course, be concerns that rising food prices could spark inflationary expectations. But the probability of that is low as food prices are likely to ease in the coming months following the seasonal trend. The promising Rabi crop prospects also will reduce food price pressures. Under these circumstances, the downside risks to any tightening now are high with virtually no upside.
86. The third argument for maintaining the accommodative monetary stance for now is that any reversal at this stage will harden yields on government bonds putting upward pressure on interest rates and dampening both consumption and investment demand. This could seriously unravel the incipient recovery.
87. Finally, capital flows have resumed on the promise of India’s growth prospects. It is argued that if we tighten ahead of other economies, the wider interest rate differential will become a perverse incentive for even larger capital flows. In managing capital flows in excess of the current account deficit, the economy will have to pay a cost which will be a combination of exchange rate appreciation, larger systemic liquidity and fiscal costs of sterilisation.
88. The Reserve Bank has studied these arguments. Some of the arguments are persuasive and some less so. The balance of judgment at the current juncture is that it may be appropriate to sequence the ‘exit’ in a calibrated way so that while the recovery process is not hampered, inflation expectations remain anchored. The ‘exit’ process can begin with the closure of some special liquidity support measures.
89. It will be recalled that in response to the crisis, like most other central banks, the Reserve Bank too instituted both conventional measures and unconventional measures. While reversing of conventional measures is not considered appropriate for now, many of the unconventional measures can be reversed immediately. The following measures constitute the first phase of ‘exit’.
90. The statutory liquidity ratio (SLR), which was reduced from 25 per cent of demand and time liabilities to 24 per cent, is being restored to 25 per cent. The limit for export credit refinance facility [(under section 17(3A) of the RBI Act], which was raised to 50 per cent of eligible outstanding export credit, is being returned to the pre-crisis level of 15 per cent. The two non-standard refinance facilities: (i) special refinance facility for scheduled commercial banks under section 17(3B) of the RBI Act (available up to March 31, 2010), and (ii) special term repo facility for scheduled commercial banks (for funding to MFs, NBFCs, and HFCs) (available up to March 31, 2010) are being discontinued with immediate effect. Details in this regard are indicated in the subsequent sections of this Statement.
91. On the basis of the above overall assessment, the stance of monetary policy for the remaining period of 2009-10 will be as follows:
• Keep a vigil on the trends in inflation and be prepared to respond swiftly and effectively through policy adjustments to stabilise inflation expectations.
• Monitor the liquidity situation closely and manage it actively to ensure that credit demands of productive sectors are adequately met while also securing price stability and financial stability.
• Maintain a monetary and interest rate regime consistent with price stability and financial stability, and supportive of the growth process.
92. In conclusion, it bears emphasis that the Reserve Bank is mindful of its fundamental commitment to price stability. It will continue to monitor the price situation in its entirety and will take measures as warranted by the evolving macroeconomic conditions swiftly and effectively.
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