Third Quarter Review of Monetary Policy 2010-11
-Announced on the 25th January 2011
II. Outlook and Projections
27. With advanced economies showing firmer signs of sustainable recovery, global growth in 2010 is expected to have been less imbalanced than before. While growth in advanced economies may improve, growth in EMEs, which have been the main engine of global economic growth in the recent period, may moderate due to tightening of monetary policy to address rising inflationary concerns and the waning impact of the fiscal stimulus measures taken in the wake of the global financial crisis.
28. Even as a large slack persists, inflation has edged up in major advanced economies owing mainly to increase in food and energy prices. Inflation in the Euro area exceeded the European Central Bank’s (ECB) medium-term target for the first time in more than two years in December 2010. Similarly in the UK, the headline inflation has persisted above the target of the Bank of England. In the US, the headline CPI rose to 1.5 per cent in December 2010 from 1.1 per cent in November 2010. Whereas signs of inflation in the advanced countries are only incipient, many EMEs have been facing strong inflationary pressures, reflecting higher international commodity prices and rising domestic demand pressures.
29. Significantly, food, energy and commodity prices are widely expected to harden during 2011, driven by a combination of supply constraints and rising global demand, as the advanced economies consolidate their recovery. This suggests that inflation could be a global concern in 2011.
30. On the domestic front, the 8.9 per cent GDP growth in the first half of 2010-11 suggests that the economy is operating close to its trend growth rate, powered mainly by domestic factors. The kharif harvest has been good and rabi prospects look promising. Good agricultural growth has boosted rural demand. Export performance in recent months has been encouraging.
31. With the risks to growth in 2010-11 being mainly on the upside, the baseline projection of real GDP growth is retained at 8.5 per cent as set out in t he Second Quarter Review of Monetary Policy of July 2010 but with an upside bias (Chart 1).
32. The moderation in headline inflation observed between August and November 2010 was along the projected trajectory of the Reserve Bank. This trend, however, reversed in December 2010 due mainly to sharp increase in the prices of vegetables, mineral oils and minerals.
33. While the current spike in food prices is expected to be transitory, structural demand-supply mismatches in several non-cereal food items such as pulses, oilseeds, eggs, fish and meat and milk are likely to keep food inflation high. Non-food manufacturing inflation also remains significantly above its medium-term trend of 4 per cent. The Reserve Bank’s quarterly inflation expectations survey, conducted during the first fortnight of December 2010, indicates that expectations of households remain elevated.
34. Going forward, the inflation outlook will be shaped by the following factors. First, it will depend on how the food price situation – both domestic and global – evolves. Domestic food price inflation has witnessed high volatility since mid-2009 due to both structural and transitory factors. A significant part of the recent increase in food price inflation is due to structural constraints. This is reflected in the less than expected moderation in food price inflation even in a normal monsoon year. There has also been a sharp increase in the prices of some food items due to transitory supply shocks. What is more worrying is the substantial increase in pr ice s of sever a l food items even though their production has not been affected. As a result, the usual moderation in vegetable prices in the winter season has not materialised.
35. Notably, high food pr ice inflation is not unique to India. Food prices have spiked in many countries in the recent period. India is a large importer of certain food items such as edible oils, and the domestic food price situation could be exacerbated by the increase in global food prices. This, therefore, poses an additional risk to domestic food price inflation.
36. The second factor that will shape the inflation outlook is how global commodity prices behave. Prices of some commodities rose sharply in the recent period even as the global recovery was fragile. Should these trends continue, they will impact inflation, domestically and globally.
37. The third factor is the extent to which demand side pressures may manifest. This risk arises from three sources, viz., the spill-over of rising food inflation; rising input costs, particularly industrial raw materials and oil; and pressure on wages, both in the formal and informal sectors. The rise in food inflation has not only persisted for more than two years now, the increase has been rather sharp in the recent period. This cannot but have some spill-over effects on generalised inflation, particularly when the growth momentum is strong and both workers and producers are likely to have pricing power. There are indications that, in the corporate sector, the share of wages in total costs is increasing. The indexation of the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) wages will also raise the wage rate in the agricultural sector. Further, besides oil, the prices of some primary non-food articles have risen sharply in the recent period. Since these are inputs into manufactured products, the risk to headline inflation is not only from the increase in non-food items but also because the increase in input costs will ultimately impact output prices. As the output gap closes, corporates will also be able to sustain higher output prices. In the absence of commensurate increase in capacity, there is the risk of demand side pressures accentuating.
38. In the Second Quarter Review of November 2010, the Reserve Bank set out the baseline projection of WPI inflation for March 2011 at 5.5 per cent, based on the new WPI series (2004-05=100). The Mid-Quarter Review of December 2010 indicated that the risks to inflation going forward were largely on the upside. Some of these risks have materialised as reflected in the increase in the prices of metals and non-administered fuel. There have also been some transitory supply shocks as reflected in the sharp increase in vegetable prices. In addition, petroleum and aviation turbine fuel prices were raised in early January which will add 9 bps to WPI inflation.
While the impact of transitory factors is expected to wane, the price pressures on account of demand-supply imbalances in respect of some commodities will persist. Considering the increase that has already occurred and the emerging domestic and external scenario, the baseline projection of WPI inflation for March 2011 is revised upwards to 7.0 per cent from 5.5 per cent
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