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Inflation projection left to the Rain Gods

Jul 27, 2010

The RBI did its quarterly ritual of reviewing the liquidity controls today. The annual Monetary Policy, as it is called in economic parlance, enjoys more frequent reviews these days. Does the RBI have any option but to keep up with its hyperactive global peers? We do not think so. Especially in the light of the ever changing dynamics of global economy.

The central bank itself seems to have had a change of opinion with regard to the global economy's near term fate. Greece's tryst with junk rating and 'soft spots' in the US economy have been the key reason for the same. As far as domestic economy is concerned, the central bank is not too confident either. It did endorse the IMF's projection of higher GDP growth. Its own projection for FY11 is 8.5%. However, when it came to inflation, the projection has pretty much been left to the Rain Gods. While the RBI has put forth a tentative number of 6% (WPI) by the end of this fiscal, there is very little certainty. There is a probability of this going as high as 8% and as low as 4%. Secondly, it is also banking on softening global energy prices. This it believes will offset the impact of recent fuel price hikes.

When it comes to using its monetary tools, the RBI has always been very partial to the repo rates. This is the rate at which the banks borrow from the RBI. It is the easiest to maneuver without impacting the banking system substantially. Hence the repo rates and reverse repo rates have been most often used in the monetary tightening since 2008.

The RBI has revised the repo rate upwards by 0.25%. On the other hand, the reverse repo rate (rate at which banks lend to RBI) has been hiked by 0.5%. What this means is that the RBI wishes to persuade banks to borrow less from it and instead keep more money with the RBI. The obvious impact of this will be in the form of liquidity being sucked out from the banking system. Not that this will impact money supply and credit growth. The RBI has retained its earlier prediction of credit growth of 20% for FY11. The growth so far (1QFY11- at 22%) has marginally exceeded its estimate.

One notable factor in this review is the non mention of fiscal deficit. The bumper 3G telecom auctions and fuel price hikes seem to have completely addressed that concern. Thus, while the RBI's tone seemed to be far more optimistic on the domestic scenario, inflation stuck out as the grey area.

Interestingly, the RBI has this time also commented on inflation in advanced economies. It believes that inflation scenario in advanced economies has been shaped by high unemployment and low capacity utilization. In fact the prospects of deflation have re-emerged. In contrast rapid recovery in emerging economies like India, China has been accompanied by faster growth in prices.

On the trend in commodity prices, the RBI believes that the near term upside is limited. Reinforced by lower demand from China, global commodity prices are expected to remain soft for some time now. In the mean time, all focus lies on tempering the price rise in India.

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