Inflation has taken the centre-stage in the macro-economic environment, as reflected in the First Quarter Policy Statement by Governor Dr Subba Rao on July 27, as well as in RBI's review of the economy and monetary and credit policy covering the April-June quarter. Indeed, the rapidly evolving situation has necessitated RBI to opt for mid-quarterly reviews to communicate its assessment of economic conditions more frequently. It would give more flexibility to calibrate monetary policy and remove the element of surprise in off-cycle policy actions.

While RBI has also revised its growth projection to 8.5 per cent in 2010-11, with domestic economic recovery firmly in place, inflationary pressures have become generalized with demand side pressures clearly evident, the statement said. Capacity constraints are visible in several sectors. “Lower policy rates can complicate the inflation outlook, given the increasing generalization of inflation”.

The statement said its new actions are expected to moderate inflation by reining in demand pressures and inflationary expectations, maintain financial conditions conducive to sustaining growth, and generate liquidity conditions consistent with more effective transmission of policy actions. It would also reduce the volatility of short-term rates.

RBI has also revised its projection on inflation to 6 per cent by March 2011 as against the 5.5 per cent in the April policy statement. Indicative targets for money supply (M3) and non-food credit growth have been retained at 17 per cent and 20 per cent respectively.

The main risk to the envisaged growth scenario emanates from global uncertainties in the aftermath of the sovereign debt crisis in some European countries and other visible weaknesses in Europe and US.

These have renewed concerns about sustainability of global economic recovery If the global recovery falters, the risk of which has increased since the April 2010 policy announcement, the performance of emerging market economies is likely to be adversely affected. While India's trade linkages with the advanced economies are relatively smaller than other emerging economies, a widespread slowdown in global trade will have an impact on important manufacturing and service sectors.

There could be a potential slowdown in capital inflows for these economies including India because of increasing risk aversion among global investors. Apart from narrowing the comfortable buffer between the current account deficit and net capital inflows for India at present, this may constrain domestic investment, which is critical to achieving and sustaining high growth rates.

The Governor said it had become imperative to continue in the direction of normalizing policy instruments to a level consistent with evolving growth and inflation scenario while taking care not to disrupt recovery. On liquidity, the statement noted that current market conditions indicate that while liquidity pressures would ease, the system is likely to remain in deficit mode. Calibrated normalization of monetary policy may not lead to return to persistent easy liquidity conditions that prevailed last year. RBI says banks therefore have to step up mobilization of depositions to meet demand for credit from both private sector and government.

The policy stance in the statement is intended “to contain inflation and anchor inflationary expectations, while being prepared to respond to any further build-up of inflationary pressures”. It is also to maintain an interest rate regime consistent with price, output and financial stability and actively manage liquidity to ensure that it remains broadly in balance so that excess liquidity does not dilute the effectiveness of policy rate actions.

On growth outlook, RBI cites most business surveys and professional forecasts for improved business sentiment and economy on an 8.1 to 8.5 per cent plus growth path in 2010-11, but cautions that the indications of pick up in private consumption demand (from trends in production of consumer durables and also auto sales) as well as in investment demand would need to be sustained for India moving into higher growth trajectory. Also, an uncertain external environment (European sovereign debt crisis) is a major risk to growth in the near term.

Meanwhile, pick-up in demand for credit from private sector, rapid growth in corporate sales and forward looking surveys indicate strengthening of domestic demand. Growth in government consumption demand is likely to moderate, reflecting the fiscal consolidation programmed in the Budget. Overall, private consumption and investment demand would be the two major drivers of growth dur4ing 2010-11, RBI said in its macro-economic review released a day earlier.

It is clear from a reading of RBI review that Government has, far from any effective measures to arrest inflation, revised administered prices for several products. With upward revision in administered prices, RBI said, suppressed inflation became more open leading to overall increase in inflation. Between November 2009 and June 2010, WPI increased by about 51 per cent and changes in administered prices have contributed as much as 42 per cent increase in WPI.

WPI stood at 10.6 per cent in June, maintaining a double digit for five consecutive months. Food items, as key driver of inflation, has been replaced by fuel and metals. While the year-on-year inflation on July 10 was 16.5 per cent for primary articles and 14.3 per cent for the fuel group, rise in manufactured products was 7.3 per cent in June 2010.

Also, RBI noted, prices of food items in India have not come down to pre-global crisis period, though global inflation in several food items eased over recent months. Food prices have remained high despite rising stock of foodgrains well above buffer norms (58.4 million tones on July 1). The policy on food management would need to focus on better supply management in relation to demand besides addressing structural capacity constraints in food items, according to RBI.

On infrastructure, RBI notes the pace of growth has lagged behind the rate of industrial growth and this would further widen infrastructure gap. Sustainability of current buoyancy in industrial and service growth would require large additions to capacity as otherwise it could become risk to overall growth like inflation. (IPA Service)