Mid-Quarter Monetary Policy Review: September 2010
RBI increase 50 bps in reverse repo and 25 bps in repo rate
September 16, 2010:
With reference to government finances, the fiscal deficit appears to be conforming to the estimates made in the Union Budget for 2010-11. Higher than expected realisations on 3G and broadband wireless access (BWA) auctions combined with buoyant tax revenues have virtually eliminated the risk of the fiscal deficit overshooting the targeted 5.5 per cent, even after the supplementary demand for grants is taken into account. This will help stabilise market expectations of liquidity and interest rate movements.
Liquidity has been a significant factor in monetary policy considerations in recent months. The lead-up to the July policy review saw the liquidity situation transit from a large surplus to a mainly deficit one, making the repo rate the operative policy rate. Consequent on this transition, the transmission from policy rates to market rates has strengthened, with 40 banks raising their deposit rates and 26 raising their lending rates. These circumstances are expected to prevail, maintaining the repo rate as the effective policy rate and sustaining the strength of the transmission mechanism.
On the external front, the continuing sluggishness of the global economy constrains export growth while the strong domestic recovery has increased demand for imports. As a result, the trade deficit, and with it the current account deficit, are widening. In its July policy review, the Reserve Bank had highlighted the risks associated with a widening current account deficit in the face of increasingly volatile capital inflows. The apparent stabilisation in advanced economies visible over the past few weeks appears to have improved global investor sentiment, resulting in a steady increase in capital inflows into EMEs, including India. If this trend continues, the risks on the external front will clearly abate despite exports remaining sluggish.
Overall, our assessment is that growth remains steady, though the recent volatility in industrial production raises some concerns. Inflation also appears to have stopped accelerating though the rate may remain high for some months. The early signs of a downturn in non-food manufacturing inflation suggest that recent monetary actions are having an impact on both inflationary expectations and demandin a non-disruptive way. Should the global situation stabilise, it will help contain volatility in capital flows. But the flip side of that will be possible firming of commodity prices and consequent inflationary pressures.
The measures undertaken in this review should:
contain inflation and anchor inflationary expectations without disrupting growth.
reduce the volatility in overnight call money rates, thereby strengthening the monetary transmission mechanism.
continue the process of normalisation of the monetary policy instruments.
The Reserve Bank’s rate and liquidity actions since October 2009 have been driven by two considerations: normalisation of the monetary policy stance as the crisis abated and inflation management. The Reserve Bank believes that the tightening that has been carried out over this period has taken the monetary situation close to normal. Consequently, the role of normalisation as a motivation for further actions is likely to be less important. Current and expected macroeconomic conditions will be the more important considerations going forward. The Reserve Bank will continue to monitor these conditions, particularly the price situation, and take further action as warranted.
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