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Second Quarter Review of Monetary Policy 2012-13 click here

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RBI's Second Quarter Review of Monetary Policy 2012-13 - 30th Oct 2012

II. Outlook and Projections

Global Outlook


32. Global growth prospects have deteriorated further and downside risks have increased, even as monetary policy in AEs remains supportive. Much depends on concrete policy actions in the euro area to ease the sovereign debt stress, balance growth-friendly structural reforms with fiscal consolidation, and carry forward integration at the area level, particularly in banking and fiscal domains. In the US, determined political resolve to agree on a credible medium-term fiscal consolidation strategy is critical to averting the fiscal cliff and to avoid once again encountering the debt ceiling deadline. In the absence of these efforts, the outlook for AEs appears bleak, with the risks of a prolonged downturn more real than before. Spillovers from AEs present a serious downside risk to the prospects for EDEs, notwithstanding their relatively stronger fundamentals and absence of financial strains.

33. In its October 2012 World Economic Outlook (WEO), the IMF scaled down its projection of world GDP growth for 2012 to 3.3 per cent from its July projections of 3.5 per cent, and for 2013 to 3.6 per cent from its earlier projection of 3.9 per cent. Since September 2011, the IMF has been scaling down its projection of global growth for 2012, evidencing persistent and more than anticipated weakness in the global economy.


34. According to the IMF (WEO, October 2012), consumer price inflation is likely to decline from 1.9 per cent in 2012 to 1.6 per cent in 2013 in AEs, and from 6.1 per cent to 5.8 per cent in EDEs. As a result of weakening of global economic activity, headline and core inflation are expected to ease. However, risks to this outlook remain as global commodity prices, particularly of crude oil, have corrected only marginally. Further accommodation in monetary policy in major AEs is likely to work in conjunction with supply constraints to keep commodity prices elevated and volatile.

Domestic Outlook


35. In its April 2012 Policy, the Reserve Bank projected GDP growth for 2012-13 at 7.3 per cent. In the First Quarter Review (FQR) of July, this was revised downwards to 6.5 per cent on an assessment that risks to domestic growth from the global slowdown, weak industrial activity and slower growth of services had materialised. By the time of the Mid-Quarter Review (MQR) of September, growth risks had heightened on account of worsening global macroeconomic conditions, decline in domestic industrial activity and service sector growth falling below trend.

36. Since then, global risks have increased further and domestic risks have become accentuated by halted investment demand, moderation in consumption spending and continuing erosion in export competitiveness accompanied by weakening business and consumer confidence. Although industrial output picked up marginally in August and the services PMI showed a modest improvement in September, the outlook remains uncertain. Notwithstanding the improvement in rainfall in the months of August and September, the first advance estimates of the 2012 kharif production are somewhat less buoyant in comparison to the previous year. Accordingly, even while prospects for agriculture appear resilient, the overall outlook for economic activity remains subdued. On these considerations, the baseline projection of GDP growth for 2012-13 is revised downwards to 5.8 per cent .


37. Looking ahead, the path of inflation will be shaped by two sets of counteracting forces. On the downside, slower growth and excess capacity in some sectors will help moderate core inflation. Stable, or in the best case scenario, declining commodity prices will reinforce this tendency. An appreciating rupee will also help to contain inflationary pressures by bringing down the rupee cost of imports, especially of commodities. On the upside, persistent supply constraints may be aggravated as demand revives, resulting in price pressures. Rupee depreciation, which may result from global financial instability, will add to imported inflation. An important driver of inflation is the upsurge in both rural and urban wages, which is exerting cost-push pressures. Finally, as under-pricing in several products is corrected as part of the fiscal consolidation process, suppressed inflation is being brought into the open. As necessary a step as this is, it will result in higher inflation readings.

38. Taking into consideration the above factors, the baseline projection for headline WPI inflation for March 2013 is raised to 7.5 per cent from 7.0 per cent indicated in July (Chart 2). Importantly, it is expected to rise somewhat in Q3 before beginning to ease in Q4.

39. Although inflation has remained persistently high over the past two years, it is important to note that during the 2000s, it averaged around 5.5 per cent, both in terms of WPI and CPI, down from its earlier trend rate of about 7.5 per cent. Given this record, 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 is in line with the medium-term objective of 3.0 per cent inflation consistent with India’s broader integration into the global economy.

Monetary Aggregates

40. Money supply (M3), deposit and credit growth have so far trailed below the indicative trajectories of the Reserve Bank indicated in the April Policy and reiterated in the July Review. Deposit growth has decelerated with the moderation in interest rates, especially term deposits. Credit growth has ebbed with the slowdown in investment demand, especially with regard to infrastructure, and lower absorption of credit by industry, in general. Keeping in view the developments during the year so far and the usual year-end pick-up, the trajectories of the monetary aggregates for 2012-13 are projected at 14.0 per cent for M3, 15.0 per cent for deposit growth and 16.0 per cent for growth of non-food credit. As always, these numbers are indicative projections and not targets.

41. The wedge between deposit growth and credit growth, in conjunction with the build-up of the Centre’s cash balances from mid-September and the drainage of liquidity on account of festival-related step-up in currency demand, have kept the system level liquidity deficit high, with adverse implications for the flow of credit to productive sectors and for the overall growth of the economy going forward.

Risk Factors

42. The projections of growth and inflation for the remaining part of 2012-13 are subject to several risks as detailed below:

i) Downside risks to growth emanating from the global macroeconomic environment are now adjudged to be more elevated than at the time of the FQR of July and the MQR of September. Weak growth momentum and policy uncertainties are impacting the macroeconomic outlook of EDEs. Spillovers to the Indian economy through trade, finance and confidence channels could increase. Domestically, a revival in investment activity, which is key to stimulating growth, depends on a number of factors. In particular, recent policy announcements by the Government, which have positively impacted sentiment, need to be translated into effective action to convert sentiment into concrete investment decisions.

ii) On the inflation front, despite recent moderation, global commodity prices remain high. While oil prices appear to have stabilised, balancing between weak demand prospects and abundant liquidity, upside risks from persistently high liquidity and geopolitical developments remain. Further, domestic prices of administered petroleum products do not reflect the full pass-through of global commodity prices, and under-recoveries persist. While corrections are welcome from the viewpoint of overall macroeconomic stability, their second-round effects on inflation will have to be guarded against. As regards food prices, drought conditions in important foodgrain producing areas of the world are likely to impart an upside and persistent bias to international food prices with adverse implications for all countries that have relatively high weights for food in their inflation indicators. The behaviour of food inflation will also depend on the supply response in respect of those commodities characterised by structural imbalances, particularly protein items. Finally, the persistent increase in rural and urban wages, unaccompanied by commensurate productivity increases, is also a source of inflationary pressures.

iii) The large twin deficits, i.e., the current account deficit and the fiscal deficit continue to pose significant risks to both growth and macroeconomic stability. A large current account deficit poses challenges for financing it in the current global environment. In a situation of volatile capital flows, the deficit could exacerbate downward pressures on the rupee. A persistently large fiscal deficit reduces the space for a revival in private spending, particularly investment spending, without quickly re-kindling inflationary pressures.

iv) Liquidity pressures pose risks to credit availability for productive purposes and could affect overall investment and growth prospects adversely. On the other hand, excess liquidity could aggravate inflation risks.

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