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Click Here for Main Page of First Quarter Review



Stance of Monetary Policy for the Remaining Period of 2005-06 Mid-term Review- July 26, 2005


34. At the time of presentation of the annual policy Statement, the Reserve Bank faced two major challenges: one, reining in inflationary expectations in the face of several uncertainties so as to ensure stability in the financial markets and maintaining financing conditions at levels appropriate to lend support to the ongoing growth momentum; and two, liquidity management in the context of budgeted government borrowings and indications of strong credit growth. The Reserve Bank sought to moderate inflationary expectations by demonstrable commitment to price stability as reflected in the increase in policy reverse repo rate by 25 basis points to 5.0 per cent. The financial markets responded positively to this measure. With increasing absorption of capital flows by the economy and changes in the sources of liquidity, the overall MSS cap was retained at Rs.80,000 crore. The lower mobilisation through MSS coupled with the reduction in LAF volumes during 2005-06 so far reflects unwinding of liquidity, as appropriate.

35. The conduct of monetary policy during the first quarter of 2005-06 has been in accordance with the stance announced in the annual policy Statement. The macroeconomic developments and conditions in financial markets have been broadly in line with anticipations in the annual policy Statement but, some developments need attention. First, overall industrial growth has maintained a healthy up trend, though the delayed monsoon has imparted some uncertainties to the likely level of agricultural production. The impact of the monsoon on agricultural production would depend on both inter-temporal and spatial distributions. Second, non-food credit growth has been significantly buoyant and is getting broad-based. However, the upswing continues to be driven by housing and real estate and hence a greater need to ensure credit quality. Third, despite higher credit growth, governments' borrowing programme has been conducted smoothly. While bank deposit growth is higher and non-bank financial institutions' demand for government securities remains positive, the competing demand for funds between the government and the commercial sector has been balanced. This has been facilitated by refocusing of the banks' operations in favour of the commercial sector relative to government duly supported by appropriate liquidity management by RBI. Fourth, money supply growth has been within the projected trajectory. Reserve money growth has been driven by expansion in domestic assets rather than foreign exchange assets. Fifth, the inflationary outcome turned out consistent with the anticipation at the beginning of the year and underlying inflation remains contained. However, the pass-through of oil prices is not yet complete. Sixth, financial markets remained stable though interest rates have shown some upward movement in consonance with the policy developments. Seventh, domestic financing conditions remain supportive of growth. Eight, the liquidity needs of the economy have been met by unwinding of liquidity in an orderly manner, though the overhang of liquidity continues to remain substantial. Ninth, an enlarged trade deficit, on account of high oil prices and improvement in absorptive capacity of the economy, was partly offset by the buoyancy in net invisibles, and net capital inflows have financed the current account deficit of BoP. The trends in oil economy and enhanced growth in industrial production and domestic investment activity point to the criticality of the trade deficit and the overall BoP. While it is necessary to monitor these developments carefully and respond in a measured manner, as per current assessment, the trade deficit is manageable and the current account deficit sustainable.

36. Though the outlook for global growth and inflation remains broadly unchanged since the presentation of the annual policy Statement in April 2005, the risks have increased in recent months. The world economy has so far accommodated the large increase in international oil price without any major disruption, but strains are increasingly becoming visible which could further impair global growth and trade. The oil prices continue to remain high and volatile. While the international interest rate cycle gives a mixed signal, the policy rate of the US is on an upward trajectory which has implications for capital inflows to emerging markets. The recently announced changes in the exchange rate policy of China add to the uncertainties.

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