RBI, in confining its tightening response to CRR alone, has not downplayed the serious risks underlying the current inflationary trends with WPI itself registering 8 per cent between April and December 2009, and it has now raised the end-March level to 8.5 per cent from its mid-year estimate of 6.5 per cent. RBI says it would continue to monitor macroeconomic conditions, particularly, the price situation closely and take further action as warranted.

Thus, contrary to expectations in some quarters, heightened by RBI's own red signals over inflation, the repo and reverse repo rates are retained at 4.75 and 3.25 per cent respectively.

CRR would be increased to 5.75 per cent of the net demand and time liabilities (NDTL) of the banking system in two stages, a rise by 50 basis points to be effective the fortnight beginning February 13, 2010, followed by the next increase of 25 basis points in the fortnight beginning February 27, 2010.

The expected outcomes of Friday's announcement are that the reduction in excess liquidity would help anchor inflationary expectations, the recovery process would be supported without compromising price stability and that the calibrated exit (from the hitherto accommodative stance) would align policy instruments with the current and evolving state of the economy.

Notwithstanding the serious threat that is posed by persistent double-digit food price inflation, which has begun showing signs of transmitting into general price level, RBI Governor Dr Subba Rao was faced with the “delicate challenge” of reconciling the need of supporting strong return to high growth with averting a generalised inflation.

But the steep rise in prices of food and other essential commodities is mainly related to supply side constraints. Government's actions on this front have been tardy and for long left to be taken care of by time.

Nevertheless, RBI's III quarter policy review has underlined the serious risks ahead of the emergence of a “growth and inflation mix”. The policy statement has, however, raised its earlier projections of GDP growth to 7.5 per cent, assuming zero growth in agricultural production and continued industrial recovery and service sector activity. While the indicative target of 17 per cent for aggregate deposits' growth remains, the lower credit offtake has led RBI to revise down non-food credit growth from 18 to 16 per cent in 2009-10. The anticipated increase in credit demand can be easily met from the market as adequate liquidity is available in the system, RBI says. Also, the targeted 18 per cent is unlikely to be realised in view of the increased availability of funds from domestic non-bank and external sources for the corporate sector.

RBI's macro-economic survey released ahead of the Third Quarter (October-December) Review of the Monetary and Credit Policy noted that the surge in food price inflation was, already exhibiting signs of generalised inflation since December. Rising headline inflation (WPI) at 7.3 per cent in December (8.021 per cent in the current fiscal till December) with a heavy concentration of essential consumption articles, mainly food items, at 21.9 per cent, brought inflation as “major concern”, dominated by supply-side factors. A strong recovery can make inflation a more generalised process. “Reigning in inflation and inflationary expectations, while carefully nurturing growth impulses, will be the main challenge for the conduct of monetary policy during the remaining period of the year,” RBI said.

The dominance of food prices as the key driver of inflation in recent months, attributable to domestic supply side pressures, indicates a limited role for demand management in effectively curbing the price pressures. But, RBI said, persistence of food price inflation over a long period could erode the purchasing power of the public at large who may be compelled to devote larger share of their disposable income to food consumption. Moreover, high food inflation and elevated CPI inflation could potentially generate wage-price spiral and raise inflationary expectations.

Professional forecasters for RBI raised their growth estimate for 2009-10 to 6.9 per cent, based on a likely 6.5 per cent in III quarter (to be announced by CSO in February) and 7.5 per cent in the last quarter (January-March). Growth in the first half of the year was 7 per cent. Recovery in the current year thus far has been led by industrial performance and fiscal expenditure driven services. RBI said the “delicate challenge” for the monetary policy was to balance the needs of supporting strong return to high growth while avoiding a situation of generalised inflation. The inflation risk looms larger in the context of global price movements on uptrend.

At the same time, domestic consumption and investment demand are yet to pick up. While the economy is steadily gaining momentum, public expenditure continues to play a dominant role and performance across sectors is uneven, suggesting that recovery is yet to become sufficiently broad-based. With the Union Budget to be presented on February 26, RBI has withheld any growth projection for the next fiscal year. It expects current growth to be maintained. Both growth and inflation projections for 2010-11 will be given in the next annual policy statement on April 20.

There are imponderables like the monsoon and global oil and other commodity prices. If the monsoon is normal and oil prices remain around current level in the range of 75-80 dollar as barrel, inflation could moderate from July 2010, according to RBI but it would also depend on other factors including measures taken both on fiscal and monetary side as part of the normalisation process.

On capital flows, RBI acknowledges any sharp increase above the absorptive capacity of the economy might complicate exchange rate and monetary management. So far, the capital flows have helped to finance the current account deficit which had risen to over 18 billion dollars in the first half of 2009-10. India's improving growth prospects, combined with persistently high levels of global liquidity, may result in a significant increase in net inflows over the coming months, RBI said, in which case, it would have implications in terms of a combination of exchange rate appreciation, larger systemic liquidity and the fiscal costs of sterilisation.

In the main, RBI has kept the interest rate structure on hold which should be welcome to the market while the corporate sector would in addition look for the budget to further promote recovery without any premature withdrawal of stimulus. There is no relief for millions of depositors in the banking system with interest rates significantly lower than the prevailing inflation. (IPA Service)