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Tuesday, February 2, 2010

Worried about increasing food prices?

Is this article for you? Caution if you are not interested to know intricacies of reserve bank and monetary policies! This article contains HEAVY finance terminology and analysis of recent moves from RBI to control inflation. You many want to reconsider your decision to read this article if you are already pre-occupied at work.

RBI Monetary Policy Review – fighting inflation

In the third quarter review of monetary policy for the year 2009-10, RBI surprised the markets a tad by hiking the CRR by 0.75%. the expectation from purists was a hike of 0.5% which indicated inflation was higher than the expected normal. However it did not touch the reverse repo and repo rates at 3.25% and 4.75% respectively which was along expected lines. The hike in CRR means that banks have to place an additional Rs.36,000 crores with the central bank. RBI has tightened the monetary policy. Both the policy document and post-policy comments by the RBI Governor emphasized this point. The central bank also reiterated its intention to:

Ø Anchor expectation about inflation and keep an eye on movements in inflation so that it is prepared to act swiftly through policy adjustments as required.

Ø Manage liquidity in market to ensure that credit demands of productive industries are adequately met in line with price stability.

Ø Maintain interest rate environment in line with price and financial stability which aids process of growth.

Points to note from policy amendments

Ø RBI increased India GDP growth estimate for 2010 from 6%to 7.5%. This is mainly due to revival in export owing to improvement in global economy, improved business optimism, better financing conditions and good recovery in industrial production and services sector performance.

Ø On inflation front, RBI has upped its estimate to 8.5% by end-March 2011 in the wake of little seasonal moderation in food prices. However RBI expects inflation to moderate from July 2010 on the assumption of seasonal monsoon, stable oil prices and recent monetary measures which are taken.

Ø RBI also stressed that the opportunity to use imports to restrict food prices is quite limited due to high prices of global commodities.

Ø The central bank has reduced the non-food credit growth projection for 2009-10 from 18% to 16% on the back of increased availability of funds to corporate sector from domestic sources.

Ø RBI takes notice that fiscal deficit remains a big risk to short-term economic situation and to medium-term economic prospects.

What I make out it…

After spending months preparing markets for the exit, RBI chose to hold back on hiking rates and limited itself to absorbing liquidity. Having said that, there were some pointers to future policy decisions:

Ø The central bank reiterated that “a consolidating recovery should encourage us to clearly and explicitly shift our stance from 'managing the crisis' to 'managing the recovery'”. At the same time RBI also felt “amidst concerns about rising inflation, we must remember that the recovery is yet to fully take hold” thus reflecting a fear that “Strong anti-inflationary measures, while addressing one problem, may precipitate another by undermining the recovery, particularly by deterring private investment and consumer spending”. This could indicate that RBI does not want to send signals to slow down the growth engine.

Ø RBI recognizes that while current inflation pressures stem from the supply side, the recovery “increases the risk of these pressures spilling over into a wider inflation process”. This implies that if the recovery process manages to sustain as it has done in past 2 quarters and demand-driven inflation pressures build-up, then the RBI will not hesitate to hike policy rates.

In summary, I feel that further monetary tightening can be expected. RBI Governor pointed out in one of his post-policy interviews that he considered raising the rates as a possible policy action but refrained as he wanted to encourage creation of capacity in the economy to fight potential demand led price pressures. RBI notes that “our main policy instruments are all currently at levels that are consistent with a crisis situation than with a fast-recovering economy” thus recognizing the need to move from the current accommodative monetary stance. RBI further says that “the reversal of monetary accommodation cannot be effective unless there is a roll back of government borrowing” thus asking the government to reduce fiscal deficit in order to increase credit growth which in turn will help RBI in the tightening process.

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