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Mid-Quarter Monetary Policy Review: December 2010

December 16, 2010:

Domestic Economy


GDP growth of 8.9 per cent in Q2 of 2010-11 suggests that domestic momentum remains strong. Agricultural growth has recovered on the back of a good monsoon. After flagging during August-September, the index of industrial production (IIP) grew by over 10 per cent in October 2010. Various indicators of industrial activity, including the Purchasing Managers’ Index (PMI) also suggest a strong underlying momentum. Lead indicators of services sector activity have continued to increase at a robust pace. These developments reinforce the Reserve Bank’s projection of 8.5 per cent for real GDP growth for 2010-11 which will be reviewed in the Third Quarter Review scheduled on January 25, 2011.


After remaining in double digits for five successive months, year-on-year headline WPI inflation declined to 8.8 per cent in August 2010 and further to 7.5 per cent in November 2010. Consumer price (CPI) inflation for industrial workers and rural/agricultural labourers softened to single digit rates from August 2010, after remaining in double-digits for over a year. The overall reduction in inflation reflects moderation of food price inflation following a favourable monsoon. Food price inflation moderated from an average of 15.7 per cent in Q1 of 2010-11 to 12.3 per cent in Q2, to 10.0 per cent in October 2010 and further to 6.1 per cent in November 2010. Amongst food items, the moderation in inflation for cereals and pulses has been larger than that in inflation of protein related food items such as egg, fish, meat and milk reflecting the structural nature of food inflation. In addition, inflation for non-food primary articles such as raw cotton, raw rubber and minerals rose sharply. Reversing the declining trend in the last six months, non-food manufactured products inflation edged up to 5.4 per cent in November 2010.

Though inflation has moderated, inflationary pressures persist both from domestic demand and higher global commodity prices. The pace of decline in food price inflation has been slower than expected due largely to structural factors. There is a risk that rising international commodity prices will spill over into domestic inflation. Going forward, rising domestic input costs for the manufacturing sector combined with aggregate demand pressures could weigh on domestic inflation. The risk to the Reserve Bank’s projection of 5.5 per cent inflation by March 2011 is on the upside.


While the overall liquidity in the system has remained in deficit consistent with the policy stance, the extent of tightness has been beyond the comfort level of the Reserve Bank. This has been mainly due to persistence of large government cash balances which have averaged ` 84,000 crore since the Second Quarter Review of November, mirroring in the average net LAF repo amount of ` 1,01,000 crore. In addition, the liquidity deficit has been accentuated by structural factors such as significantly above-trend currency expansion and relatively sluggish growth in bank deposits even as the credit growth accelerated in 2010-11. While the liquidity deficit improved transmission of monetary policy signals with several banks raising deposit and lending interest rates, excessive deficits induce unpredictability in both availability and cost of funds, making it difficult for the banking system to sustain credit delivery.

In view of the persistent liquidity pressures in November 2010, the Reserve Bank implemented some measures such as additional liquidity support to SCBs under the LAF up to 2.0 per cent of their NDTL, continuation of second LAF, and OMO purchase of government securities. While these measures have helped stabilise overnight interest rates, the extent of deficit could constrain banks’ ability to expand their balance sheets commensurate with the productive needs of the economy. The additional liquidity measures initiated by the Reserve Bank respond to these concerns.

As the economy expands, it needs primary liquidity, which will have to be provided in a manner consistent with the monetary policy stance. Such provision of liquidity should not be construed as a change in the monetary policy stance since inflation continues to remain a major concern. The measures taken in this review need to be appreciated in that context.

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RBI Further Relaxes Liquidity Easing Measures; 29 Nov 2010 ....Click Here

Full Text of Second Quarter Review of Monetary Policy 2010-11....Click Here

Monetary Developments in the Second Quarter of 2010-11 ...Click Here

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