Mid-term Review of Annual Policy 2004-05- 26th Oct 2004
II. Stance of Monetary Policy for the Second Half of 2004-05
47. The annual policy Statement of May 2004 had indicated that, barring the emergence of any adverse and unexpected developments in the various sectors of the economy and assuming that the underlying inflationary situation does not turn adverse, the overall stance of monetary policy for 2004-05 will be:
Provision of adequate liquidity to meet credit growth and support investment and export demand in the economy while keeping a very close watch on the movements in the price level.
Consistent with the above, while continuing with the status quo, to pursue an interest rate environment that is conducive to maintaining the momentum of growth and, macroeconomic and price stability.
48. Monetary management in the first half of 2004-05 was conducted broadly in conformity with the monetary policy stance announced in the annual policy Statement. However, monetary management faced severe challenges on two counts. One, overhang of liquidity. Two, acceleration in headline WPI inflation beyond the anticipated level with implications for inflationary expectations. While capital inflows were not at the level of the previous year, the carry forward of liquidity into the current fiscal was over Rs.81,000 crore. The liquidity balance was complicated further by a sharp increase in reserve money in the previous year emanating largely from build-up of excess cash balances by commercial banks towards the close of the year, in fact in the last week of March 2004.
49. The Reserve Bank sought to manage the liquidity essentially through two instruments, viz., MSS and LAF. As the volumes under MSS rose, the visible liquidity under LAF declined. The reduction of liquidity under LAF helped in stabilising the yield curve at the shorter end. This was evident from the CBLO rates, market repo rates and overnight call money rates inching closer to the LAF repo rate. It was, however, noticed that there was some bunching of liquidity due to the 7-day minimum tenor of LAF repo which imparted volatility to short-term rates, particularly around the time of primary auctions of government securities. Accordingly, overnight fixed rate repo under LAF was introduced in August, in place of overnight variable rate repo discontinued in April, to smoothen liquidity flow and contain volatility. While the excess liquidity has come down with the combined effect of a slowdown in capital inflows and better domestic absorption on account of higher credit demand, it still remains substantial at around Rs.67,000 crore as reflected in the combined volume of MSS and LAF.
50. There has been an understandable impact of the inflation scenario during the current year on the government securities market. As the headline WPI inflation accelerated, government debt market reacted with considerable volatility and an overall downward movement in the gilt prices. However, markets tended to stabilise as the causes of inflation and policy responses became apparent. Consultations with banks and the prudential guidelines on classification of investment portfolio of banks into held to maturity (HTM) category issued in September also helped to reassure the markets.
51. The upward pressure on WPI inflation largely emanated from trends in international commodity prices, particularly oil. As the WPI commodity basket covers the tradable items, it rose faster than the CPI. Unlike most countries, WPI continues to be the headline inflation rate in India for various reasons. However, the increasing openness of the economy has widened the wedge between WPI and CPI. Similar divergence between price indices at the producersí level and the consumersí level has been noticed for most countries except for countries in the euro area. As between the international and domestic factors, the former continues to be dominant in explaining the increase in WPI. The international factors relate primarily to prices of oil, iron ore, coal mining and iron & steel but also, to some extent, financial markets, including interest rates and exchange rates.
52. It may be necessary to capture some nuances in outlook for and measurement of inflation and their relationship with policy response in the current context of inflationary expectations. On the issue of outlook, the rapid increases in productivity and trade liberalisation enabling the globally least-cost producer to influence setting of prices, have tended to impart a downward bias. On the issue of appropriate index of inflation, analysts point out that WPI in India is similar to producersí price index (PPI) in other countries and that, in other countries, the headline inflation is usually the CPI. More important, internationally, empirical evidence shows that WPI or PPI tends to be more volatile than CPI.
53. In this context, a recount of the divergence between WPI and CPI could be instructive. Over the last five years, average WPI inflation was 4.6 per cent and CPI inflation was lower at 3.9 per cent. In the recent years, the year-on-year WPI inflation rate was higher in the range of 6.0-9.0 per cent during most parts of 2000-01. Again, inflation remained high in the range of 6.0-7.0 per cent for sometime during 2003-04. As these inflationary episodes were considered to be largely caused by supply side factors, the inflation rate reversed itself quickly once the supply situation stabilised.
54. While the headline inflation responds to both supply shocks and demand pressures, the nature of response could be quite different. The response of inflation to supply shocks is quick but transient. The response to demand shocks on the other hand, is more subtle but persistent. As indicated in the annual monetary and credit policy Statement of April 2001, a factor which complicates the conduct of monetary policy during certain periods is the difficulty encountered in precisely assessing the potential inflationary pressures based on the available data for the current period. While there are uncertainties, it is perhaps useful to look at the recent inflation history for an assessment of inflationary expectations.
55. In the context of current inflation scenario, an issue of policy interest for financial management by banks and other market participants is whether, after a sharp decline in the past four years, the interest rate cycle has turned. As is well known, the outcome for interest rates depends mainly on the outlook for inflation, growth prospects and investment demand and it is not possible to predict short-run movements in interest rates, either up or down, without taking cognizance of possible movements in all other macroeconomic variables. These variables are also subject to unanticipated changes because of unforeseen domestic or external developments. However, the system has to recognise interest rate cycles and strengthen risk management processes to cope with eventualities so that financial stability could be maintained and interest rate movements could be passed in a non-disruptive manner.
56. As the overall assessment of the current inflation scenario shows that it is largely supply induced, the monetary authorities have to balance the pros and cons of using monetary policy instruments as a means of stabilising inflationary expectations. At the present juncture, the concern over inflation is a global phenomenon and different monetary authorities have responded differently, essentially tailoring their policy response according to their specific situations.
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