Part I. Annual Statement on Monetary Policy for the Year 2005-06
II. Stance of Monetary Policy for 2005-06
46. During 2004-05, monetary policy faced difficult challenges which prompted a change in the stance in the mid-term Review of October 2004. First, there was a carry forward of excess liquidity of over Rs.81,000 crore. Second, the headline WPI inflation accelerated beyond the anticipated level during the first half of the year. Third, the seasonal decline in food prices did not materialise fully, perhaps stemming from deficient monsoon. Fourth, international commodity prices remained high and volatile. Fifth, internationally, monetary policy stance in a number of countries was transiting from highly accommodative to a neutral level. Sixth, the pass-through of international commodity price pressures to domestic inflation had implications for inflationary expectations. Seventh, given the uncertainties, the reaction of financial markets was adverse. As interest rates were at historically low levels, the upside risk was high. There was sharp upward movement in interest rates towards the middle of the year which ensued a selling pressure in government securities market. Eighth, the equity markets touched a low on May 17 which had an adverse impact on sentiments very temporarily and markets bounced back very quickly thereafter. Finally, these developments occurred at a time when industrial growth was looking up after a prolonged period of sluggishness and non-food credit was also picking up. In the event, the Reserve Bank had to balance the considerations of growth while containing inflationary expectations. Given the role of supply factors in the nature of inflation, the response was in concert with the Government. In signalling its commitment to price stability, the Reserve Bank switched its stance from a ‘very close watch on the movements in the price level’ in the annual policy Statement to ‘equal emphasis on price stability’ in the mid-term Review. Similarly, liquidity management for the purpose was emphasised with a switch from a provision of ‘adequate liquidity’ to ‘appropriate liquidity’. The policy measures were also calibrated to evolving circumstances with a view to stabilising inflationary expectations.
47. During 2004-05, the following steps were taken in a measured and calibrated manner. First, the Reserve Bank communicated its assessment of the supply-induced nature of inflation to the market on several occasions. Second, the market was sensitised to the differential behaviour of inflation at the producers’ and the consumers’ level, the former being higher as observed in a number of other oil-importing countries. Third, the Government responded with fiscal measures, particularly by reducing customs and excise duties on oil. Fourth, corporates also responded positively by moderating the exercise of their pricing power. Fifth, 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. Sixth, for a more flexible management of liquidity, overnight fixed rate reverse repo under LAF was introduced. Seventh, CRR was raised by one-half of one percentage point to 5.0 per cent. Eighth, the remuneration of CRR was delinked from the Bank Rate and was reduced to 3.5 per cent to enhance its effectiveness as a monetary instrument. Ninth, banks were allowed to transfer their investment into HTM category up to their statutory minimum SLR requirement after providing for depreciation. While this measure provided an opportunity to banks to interface with interest rate cycles, at a macro level, it helped in maintaining financial stability. Finally, the fixed reverse repo rate under LAF was raised by 25 basis points to 4.75 per cent. However, the repo rate and the Bank Rate were left unchanged at 6.0 per cent signalling the short-term nature of upward inflationary pressures. The financial markets responded positively to the package of measures and, consequently, interest rates stabilised towards the last quarter of the year, albeit at higher levels, but lower than their intra-year highs registered during the middle of the year. Moreover, credit flow to the commercial sector remained uninterrupted and the government borrowing programme could be completed smoothly.
48. In the conduct of monetary policy, the Reserve Bank was faced with the challenge of reconciling two dominant views. As inflation was supply induced, it was argued that direct monetary policy action may be premature keeping in view the fact that industry was coming out of a sluggish phase. On the other hand, the deterioration in inflation expectations on the basis of observed acceleration in headline inflation, accompanied by sharp movements in market interest rates, tested the resolve of the central bank on price stability. Since such a deterioration occurred under conditions of overhang of excess liquidity, strong credit growth, incomplete pass-through of oil price shock and uncertainties about its second round effects, the other argument was in favour of monetary policy response to contain inflationary expectations.The received wisdom, with the hindsight of oil price shocks of the 1970s and the 1980s, is that in the face of a significant supply shock, it is not prudent for monetary policy to be overly accommodative. Moreover, globally, monetary policy was transiting in a number of countries from excessive accommodation towards a neutral position on inflation concerns. On balance of considerations, the Reserve Bank raised CRR and the reverse repo rate moderately to signal its strong commitment to price stability. In this context, it is important to note that higher levels of sustainable growth is feasible only in an enabling environment of stable prices.
49. Monetary management during second half of 2004-05 was conducted broadly in conformity with the stance of the policy set out for the second half of the year. In terms of macroeconomic outcome during 2004-05, first, the GDP growth rate turned out to be better than anticipated largely on account of higher than expected growth from agricultural sector. More importantly, GDP growth was characterised by a pick up in industrial activity which, if sustained, could lift India to a higher growth trajectory. Second, the inflationary outcome, though consistent with the anticipation at the beginning of the year, turned out to be more favourable than the perception of the mid-term Review due to moderation in prices of primary and manufactured products as well as cushioning of the oil price impact. Third, while interest rates in money and government securities markets rose intra-year, they stabilised during the later part of the year albeit at higher levels. Fourth, the pick up in non-food credit growth was generally sustained and distribution of credit became broad-based across sectors during the later part of the year. More importantly, the expansion of credit did not trigger an increase in lending rates. Fifth, the term deposit rates showed some increase. Sixth, money supply growth turned out to be lower than the projections made at the beginning of the year. Seventh, though the exchange value of the rupee vis-à-vis the US dollar depreciated at the beginning of the year, it recovered and exhibited greater two-way movement. Eighth, the trade deficit widened significantly reflecting a deficit on non-oil trade balance and higher oil imports. Ninth, though net invisible receipts are buoyant, the current account of balance of payments which remained in surplus for consecutive three years is turning into a deficit during 2004-05 reflecting adverse trade balance. While invisibles, such as private remittances have lent support to the current account, the trade account has particular relevance as it reflects the competitiveness of the underlying industrial structure and the degree of openness. Tenth, capital flows resumed after a brief pause resulting in significant increase in foreign exchange reserves during the year. Finally, corporate results and the domestic business outlook continue to remain positive.
>> GO TO NEXT PAGE
Return to main page of Annual Policy Statement for the Year 2005-06