Annual Monetary Policy Statement for the Year 2011-12- 3rd May 2011
Part A. Monetary Policy
II. Outlook and Projections
33. The global recovery is expected to sustain in 2011, although growth will slow down marginally from its pace in 2010. According to the IMF WEO (April 2011), global growth is likely to moderate from 5.0 per cent in 2010 to 4.4 per cent in 2011. Growth is projected to decelerate in advanced economies due to waning of impact of fiscal stimulus, and high oil and other commodity prices. Growth in EMEs is also expected to decelerate on account of monetary tightening and rising commodity prices.
34. The IMF WEO (April 2011) projects global CPI inflation to rise from 3.7 per cent in 2010 to 4.5 per cent in 2011. While advanced economies face inflationary pressures from high commodity prices, EMEs face pressures from both strong domestic demand and high commodity prices. CPI inflation in the advanced economies is projected to increase from 1.6 per cent in 2010 to 2.2 per cent in 2011, and in the EMEs from 6.2 per cent to 6.9 per cent.
35. Real GDP growth for 2010-11 was estimated at 8.6 per cent. Signs of moderation, however, emerged in the second half of the year. Particularly significant were the slowdown in capital goods production and investment spending. Going forward, high oil and other commodity prices and the impact of the anti-inflationary monetary stance will weigh on growth. Most business confidence surveys conducted by various agencies show a decline in business confidence. The Reserve Bank’s IOS conducted during March 2011, as mentioned earlier, indicates some moderation in business expectations for the quarter ended June 2011.
36. Growth is expected to moderate in 2011-12 from its pace in 2010-11. First, notwithstanding the preliminary indication of a normal monsoon by the India Meteorological Department (IMD) during 2011, agriculture growth is likely to revert to its trend growth from the higher base of last year. Second, the pace of industrial activity has been slowing mainly due to the impact of past monetary policy actions and high input prices. External demand too may slow if global recovery slackens.
37. Based on the assumption of a normal monsoon and crude oil prices averaging US$ 110 a barrel over 2011-12, the baseline projection of real GDP growth for 2011-12 for policy purposes is placed at around 8 per cent. The growth is projected to be in the range of 7.4 per cent and 8.5 per cent in 2011-12 with 90 per cent probability
38. The Reserve Bank's forecasts systematically under-predicted year-end inflation during 2010-11. Even after a significant upward revision from 5.5 per cent to 7 per cent in the Third Quarter Policy Review in January 2011 and then to 8 per cent in the Mid-Quarter Review in March 2011, the forecasts remained below the provisional number of 9 per cent for March 2011. The analysis in the previous section reveals that the surge in headline inflation, despite an overall moderation in food inflation, was the combination of two factors: an unanticipated increase in oil and commodity prices, including the large upward revision in administered coal prices in March 2011, and demand pressures reflected in significant increase in inflation in non-food manufactured products.
39. Against this backdrop, several factors will play a role in the inflation outlook, going forward. First, there is a significant suppressed component of inflation as the increase in crude oil prices has not been passed on completely. The last increase in administered mineral oil prices was effected in June 2010 when the Indian basket of crude oil was US$ 74.3 per barrel. Subsequently, it increased to US$ 110.7 per barrel in March 2011. Similarly, administered electricity prices have not gone up even as input prices, particularly those of coal, have increased significantly. Hence, the timing of changes in administered prices as indicated above will have a significant influence on the inflation path.
40. Second, the outlook for crude oil prices in the near future is uncertain, given the geo-political situation in the MENA region. In any case, the likelihood of oil prices moderating significantly is low. The IMF WEO (April 2011) has assumed a baseline average crude oil price of US$ 107 per barrel for 2011 and US$ 108 per barrel for 2012.
41. Third, incomplete pass-through of higher crude prices will have an impact on aggregate demand though higher subsidy expenditure, which is expansionary and can add to inflationary pressure.
42. Fourth, there have been sharp increases in the prices of several important industrial raw materials, such as minerals, fibres, especially cotton, rubber, besides coal and crude oil. In addition, there is also upward pressure on wages. The extent to which the increase in input prices translates into output prices will have an influence on the inflation path.
43. Fifth, while the south-west monsoon 2011 is expected to be normal, its impact on moderation in food inflation may be less than commensurate, given a strong structural component in food inflation and elevated global food price situation.
44. Sixth, even though demand pressures were evidently strong enough to induce the generalisation of commodity price increases in recent months, signs of moderation in growth suggest that this driver of inflation will ease in the coming months. The cumulative impact of monetary actions over the past 15 months will continue to be felt over the course of 2011-12, contributing to moderation in both growth and inflation rates.
45. Keeping in view the domestic demand-supply balance and the global trends in commodity prices and the likely demand scenario, the baseline projection for WPI inflation for March 2012 is placed at 6 per cent with an upward bias (Chart 2). Inflation is expected to remain at an elevated level in the first half of the year due to expected pass-through of increase in international petroleum product prices to domestic prices and continued pass-through of high input prices into manufactured products.
46. Notwithstanding the current inflation scenario, it is important to recognise that in the last decade, the average inflation rate, measured in terms of WPI and CPI, had moderated to around 5.5 per cent. More specifically, non-food manufacturing inflation, which the Reserve Bank uses as an indicator of demand pressures and is the most responsive to monetary actions, averaged 4.0 per cent over this period. A period of low inflation preceded the high-growth phase in 2003-08, which was in turn characterised by high investment-GDP and declining fiscal deficit-GDP ratios. Inflation remained moderate in the early part of the high-growth phase, but increased in the period immediately preceding the global financial crisis, reflecting the emergence of domestic bottlenecks.
47. Based on cross-country as well as domestic experience, the Reserve Bank is strongly of the view that controlling inflation is imperative to sustaining growth over the medium-term. This is a critical attribute of a favourable investment climate, on which growth sustainability depends. Fiscal consolidation will also contribute to improving the investment climate. Accordingly, the conduct of monetary policy will continue to condition and contain perceptions of inflation in the range of 4.0-4.5 per cent, with particular focus on the behaviour of the non-food manufacturing component. This will be in line with the medium-term objective of 3.0 per cent inflation consistent with India’s broader integration into the global economy. The achievement of this objective will be helped by concerted policy actions and resource allocations to address domestic bottlenecks, particularly on the food and infrastructure fronts.
48. Keeping in view the need to balance the resource requirements of the private sector and the budgeted government borrowings, M3 growth for 2011-12, for policy purposes, is placed at 16.0 per cent. Consistent with this, aggregate deposits of SCBs are projected to grow by 17.0 per cent. Growth in non-food credit of SCBs is projected at 19.0 per cent. These monetary projections are consistent with the growth and inflation outlook. As always, the numbers are provided as indicative projections and not as targets.
49. The indicative projections of growth and inflation for 2011-12 are subject to several risks as detailed below:
i) There are several downside risks to global growth at this stage such as (a) sovereign debt problem in the euro area periphery intensifying and spreading to the core; (b) high commodity prices, especially oil, impacting the global recovery; (c) abrupt rise in long-term interest rates in highly indebted advanced economies with implications for fiscal path; and (d) accentuation of inflationary pressures in EMEs. Should global recovery slacken significantly, it will impact the Indian economy through the trade, finance and confidence channels.
ii) Global commodity prices are a significant risk factor for both domestic growth and inflation. The future path of crude oil prices is uncertain. Brent crude crossed US$ 120 per barrel in April 2011. Metal prices, which witnessed some decline around mid-March 2011, reflecting the weakening of investor confidence due to the Japanese disaster, have resumed their upward trend.
iii) The budgeted fiscal deficit for 2011-12 gives some comfort on the demand front. However, achieving the fiscal consolidation targets for 2011-12 could be a challenge, given the subsidy burden arising out of high international prices, the effect of which has not been completely passed on. The Government, therefore, needs to focus on the quality of expenditure to sustain the fiscal consolidation process, which, in turn, will help contain aggregate demand.
iv) Food inflation, after remaining in double digits for more than two years, declined to a single digit rate in November 2010. However, despite normal monsoon in 2010, food price inflation did not show the usual moderation. Furthermore, vegetable prices also did not exhibit the usual seasonal pattern in 2010-11. This suggests that supply is not able to keep pace with the growing demand. Given the spike in international food prices even in significantly traded food items, imports do not provide an option to cushion domestic prices. Persistently high food prices are likely to exert sustained upward pressure on wages, thus transmitting through to wider cost pressure on prices.
v) If oil and commodity prices remain elevated, the CAD will remain significant. Financing of CAD is going to be a challenge as advanced countries begin exiting from their accommodative monetary policy stance. This could slow down capital inflows to EMEs, including India, as investors rebalance their portfolios.
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