First Quarter Review of Monetary Policy 2011-12


The Reserve Bank''s Annual Policy Statement of May 3, 2011 highlighted several risk factors to the growth-inflation outlook. Many of these risks have materialised. On the global front, the sovereign debt problems that have beset the euro area over the past year now threaten larger economies in the region. In the US, concerns over a sovereign default loom over financial markets, with potentially disruptive consequences for global capital flows. Japan is dealing with the challenges of recovering from the impact of the tsunami amidst deeper recessionary tendencies.

  1. In striking contrast to advanced economies, emerging market economies (EMEs) have generally been dealing with rising inflation, caused by a combination of elevated commodity prices and robust domestic demand. While the two-speed recovery has been spoken about for some time, its very different impact on advanced economies and EMEs is now clearly visible.

  2. From the perspective of India's macroeconomic policy imperatives, a critical consideration is the effect that global conditions will have on commodity prices. Since the May 3 Statement, the prices of many commodities, including that of crude oil, have shown signs of softening, reflecting weakening demand in advanced economies. Had this trend consolidated, it would have provided some welcome relief from inflationary pressures. However, one quarter later, the downtrend has not yet proved to be very strong. Prices are generally still high compared with last year. With no immediate prospects of monetary tightening in the advanced economies, the impact of weakening demand appears to be offset by that of abundant liquidity.

  3. On the domestic front, a revised and rebased index of industrial production (IIP) suggested that earlier signals of a growth deceleration in the second half of 2010-11 were exaggerated. In fact, the growth momentum remained strong throughout the year. However, data for April-May 2011 suggest that some moderation might be under way, reflecting in part a lagged response to the monetary tightening that has been effected since October 2009.

  4. Notwithstanding signs of moderation, inflationary pressures are clearly very strong. Importantly, the softening of commodity prices over the past three months did not translate into a decline in either headline wholesale price index (WPI) inflation or non-food manufacturing inflation. If the softening reverses, commodity prices are likely to exert inflationary pressures for some time, making moderation in demand necessary to bring inflation down.

  5. Overall, the current balance of global and domestic factors suggests that monetary policy needs to persist with a firm anti-inflationary stance. Moreover, moderating domestic growth will certainly help ease inflationary pressures, which may be reinforced by possible softening in global commodity prices.

  6. This policy review is set in the context of the above uncertain global and domestic economic environment. It should be read and understood together with the detailed review in Macroeconomic and Monetary Developments released yesterday by the Reserve Bank. This Statement is organised in four sections: Section I provides an overview of the global and domestic macroeconomic developments; Section II sets out the outlook and projections for growth, inflation and monetary aggregates; Section III explains the stance of monetary policy; and Section IV specifies the monetary policy measures.

    Global Economy

  7. The pace of global expansion moderated in Q2 of 2011. Several factors contributed to this - high oil and other commodity prices, supply chain disruptions from Japan, sovereign debt concerns in the euro area, and continued weakness in the US housing and labour markets.

  8. Concerns over the euro area sovereign debt problem re-emerged on the back of Greece''s deteriorating fiscal position, downgrading of Portugal''s sovereign debt rating, and most significantly, signs of stress in Italy's sovereign debt. There is heightened anxiety about whether the euro area will be able to agree on an economically viable, fiscally sustainable and politically feasible solution to the vexing sovereign debt problem. In this regard, the agreement reached by the euro zone leaders in their meeting on July 21, 2011 is a positive development. However, its effective implementation remains to be seen.

  9. Medium-term sovereign debt sustainability issues are also under debate in the US, although the near-term focus is on the constraints posed by the existing debt ceiling. The unemployment rate edged up in the US and showed no improvement in other major advanced economies. The US national home price index declined further in Q1 of 2011.

  10. International prices of oil and other commodities softened in the weeks after the May 3 Policy Statement on the back of a slowdown in economic activity, but they remain at elevated levels. Crude prices, which moderated in June 2011 on account of the decision of the International Energy Agency (IEA) members to release 60 million barrels of crude from their strategic reserves to offset supply disruptions, have edged up again. Brent crude price has ruled above US$ 110 a barrel in July 2011 so far. On a year-on-year (y-o-y) basis, the World Bank''s index of energy prices was up by 39 per cent in June 2011. Also, the Food and Agriculture Organisation''s (FAO) food price index in June 2011 was 39 per cent higher than in June 2010.

  11. Despite sluggish economic activity, inflationary pressures also emerged in advanced economies under the impact of high commodity prices. Core inflation has picked up in the US and the euro area. In view of headline inflation remaining above its target, the European Central Bank (ECB) raised its policy rate in July 2011, its second rate hike since it began to exit from its expansionary monetary stance in April 2011.

  12. Reflecting high commodity prices as well as strong demand, headline as well as core inflation in EMEs remained elevated in the first half of 2011. Inflation in China reached a 3-year high of 6.4 per cent in June 2011. Many EMEs persisted with monetary tightening in Q2 of 2011.

    Domestic Economy

  13. GDP grew by 8.5 per cent during 2010-11. This estimate could undergo some upward revision since the new IIP series (base: 2004-05) shows that industrial growth did not moderate in the second half of 2010-11 as earlier thought. Latest available data for 2011-12, however, suggest some moderation in economic activity. The increase in the IIP by 5.7 per cent in April-May 2011 was lower as compared with the increase of 10.8 per cent in the corresponding period of last year. Merchandise trade, however, registered strong growth with exports expanding by 46 per cent during Q1 of 2011-12.

  14. According to the Reserve Bank''s order books, inventories and capacity utilisation...

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