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click here to return to main page of Mid-term Review of Annual Policy for the year 2004-05
Mid-term Review of Annual Policy 2004-05- 26th Oct 2004
II. Stance of Monetary Policy for the Second Half of 2004-05
57. Given the large informal sector and the fact that a vast majority of population is not hedged against inflation, determined efforts are needed to contain inflationary expectations. In this context, careful assessment of facts and reasons on an ongoing basis is important for appropriate policy response: First, while the annual policy Statement had anticipated some upswing in prices, the actual increase was higher than expected. Second, the pick-up in inflation was predominantly a result of supply shock with global factors playing a critical part, though domestic factors such as liquidity overhang and monsoon conditions also played a role. Equally important, it is necessary to communicate the assessments and policy responses from time to time in a credible manner, both for financial markets and inflationary expectations.
58. Subsequent to the announcement of the annual policy Statement, the following calibrated responses were taken: First, the Reserve Bank communicated its assessment of the nature of inflation to the market on several occasions. Second, given the supply induced nature of inflation, the Government responded with fiscal measures, particularly relating to oil. The fiscal actions and some responses from corporates on moderating the exercise of their pricing power were part of the measured but harmonised responses along with monetary policy actions in liquidity management. Third, in order to enable the Reserve Bank to address the overhang of liquidity, the Government raised the ceiling of MSS from Rs.60,000 crore to Rs.80,000 crore. Fourth, for a more flexible management of liquidity, overnight fixed rate repo under LAF was introduced. Fifth, CRR was raised by one-half of one percentage point to 5.0 per cent. This measure reduced the liquidity in the banking system by about Rs.9,000 crore. Further, the interest rate on eligible CRR balances was delinked from the Bank Rate and was reduced to 3.5 per cent per annum. However, Reserve Bank will continue to pursue its medium-term objective of reducing CRR to its statutory minimum of 3.0 per cent. The Reserve Bank chose to increase the CRR, partly for absorbing liquidity in the system, but more importantly for signalling the Bank’s concern at the unacceptable levels of inflation so that inflationary expectations are moderated while reiterating the importance of stability in financial market conditions.
59. The Reserve Bank will continue to ensure that appropriate liquidity is maintained in the system so that all legitimate requirements of credit are met, consistent with the objective of price stability. Towards this end, RBI will continue with its policy of active demand management of liquidity through OMO including LAF, MSS and CRR, and using the policy instruments at its disposal flexibly, as and when the situation warrants.
60. In the Part I of this Review, detailed discussions have been presented on the likely levels of major macroeconomic and monetary aggregates after assessing the relevant factors. In light of the discussion, for the purpose of monetary management:
(i) GDP growth in 2004-05 is placed in the range of 6.0 to 6.5 per cent as against 6.5-7.0 per cent envisaged earlier under certain assumptions;
(ii) inflation, on a point-to-point basis, could be around 6.5 per cent as against 5.0 per cent projected earlier;
(iii) expansion in M3 would be around 14.0 per cent as projected earlier;
(iv) growth in aggregate deposits would be Rs.2,18,000 crore as projected earlier; and
(v) non-food bank credit including investments in bonds/debentures/shares of public sector undertakings and private corporate sector, commercial paper (CP) etc., is expected to increase by around 19.0 per cent, higher than 16.0-16.5 per cent projected earlier; the higher credit expansion could be accommodated without putting undue pressure on money supply because of lower borrowing of the Government from the banking sector; in the eventuality of government borrowings being larger, unwinding of MSS would facilitate such borrowings.
61. Since the announcement of the annual policy Statement in May 2004, the world economic outlook has remained stable though there are some positives and some concerns in the domestic economy: GDP growth may turn out to be slightly lower; whereas WPI inflation has firmed up, CPI inflation remains moderate; interest rates in the money and government securities markets have increased; interest rates in the bank credit and deposit markets have remained stable; the forex market also remained stable; expansion in money supply is within the trajectory and excess liquidity has remained sterilised; credit demand has been far more than anticipated; business outlook is turning out to be increasingly positive; the current account may still show a marginal surplus and capital inflows remain somewhat buoyant.
62. Looking forward, the overhang problems arising out of high international oil prices and continued high domestic liquidity continue, albeit with some moderation. There are considerable uncertainties regarding the future course of oil prices and how the shock would turn out to be globally and how it could be absorbed domestically. The increase in international oil prices is yet be reflected fully in the domestic economy. The secondary effect of oil price increase is not yet very apparent. The large first half increase in domestic credit is likely to be sustained in the rest of the year.
63. In sum, consistent with the developments during the first half of the year, barring the emergence of any adverse and unexpected developments in the various sectors of the economy and keeping in view the inflationary situation, the overall stance of monetary policy for the second half of 2004-05 will be:
Provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy while placing equal emphasis on price stability.
Consistent with the above, to pursue an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the momentum of growth.
To consider measures in a calibrated manner, in response to evolving circumstances with a view to stabilising inflationary expectations.
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