Monetary Policy Statement 2011-12


The Annual Policy for 2011-12 is set in conditions significantly different than they were a year ago. Last year''s policy was made in an environment of incipient domestic recovery amidst uncertainty about the state of the global economy, a perception that was reinforced with the precipitation of the Greek sovereign debt crisis a few weeks later. While signs of inflation were visible, they were driven primarily by food. However, food price pressure spilling over into more generalised inflation was clearly a risk as the recovery consolidated and domestic resource utilisation rose to levels which stretched capacities. Throughout the year, the goal of monetary policy was to nurture the recovery in the face of persistent global uncertainty while trying to contain the spillover of supply-side inflation.

  1. The trend of moderating inflation and consolidating growth in the second and third quarters of 2010-11 justified the calibrated policy approach of the Reserve Bank. However, the resurgence of inflation in the last quarter of 2010-11 was a matter of concern. Although the trigger was the sharp uptrend in international commodity prices, the fact that these were quickly passing through into the entire range of domestic manufactured goods indicated that pricing power is significant. In other words, demand has been strong enough to allow significant pass-through of input price increases. Significantly, this is happening even as there are visible signs of moderating growth, particularly in capital goods production and investment spending, suggesting that cumulative monetary actions are beginning to have an impact on demand.

  2. Thus, three factors have shaped the outlook and monetary strategy for 2011-12. First, global commodity prices, which have surged in recent months, are likely to, at best, remain firm and may well increase further over the course of the year. Second, headline and core inflation have significantly overshot even the most pessimistic projections over the past few months. In terms of the likely trajectory of inflation over the year, the first suggests that high inflation will persist and may get worse. The second raises concerns about inflationary expectations becoming unhinged.

  3. The third factor, countering these forces, is the likely moderation in demand, which should help reduce pricing power and the extent of pass-through of commodity prices. This cannot be ignored in the policy calculation. However, a significant factor influencing aggregate demand during the year will be the fiscal situation. While the budget estimates offered reassurance of a rollback, the critical assumption that petroleum and fertiliser subsidies would be capped is bound to be seriously tested at prevailing crude oil prices. Even though adjustment of administered retail prices may add to inflation in the short run, the Reserve Bank believes that this needs to be done as soon as possible. Otherwise, the consequent increase in the fiscal deficit will counter the moderating trend in aggregate demand.

  4. The monetary policy trajectory that is being initiated in this Annual Statement is based on the following premise. Over the long run, high inflation is inimical to sustained growth as it harms investment by creating uncertainty. Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence.

  5. Against this backdrop, this Statement sets out the Reserve Bank''s assessment of the current macroeconomic situation and projections. It is organised in two parts. Part A covers Monetary Policy and is divided into four Sections. Section I provides an overview of 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. Section IV specifies the monetary and liquidity measures, including the modified operating procedures in the light of the recommendations of the Working Group on Operating Procedure of Monetary Policy (Chairman: Shri Deepak Mohanty) and the feedback received thereon.

  6. Part B covers Developmental and Regulatory Policies and is divided into six sections: Financial Stability (Section I), Interest Rate Policy (Section II), Financial Markets (Section III), Credit Delivery and Financial Inclusion (Section IV), Regulatory and Supervisory Measures for Commercial Banks (Section V) and Institutional Developments (Section VI).

  7. Part A of this Statement should be read and understood together with the detailed review in Macroeconomic and Monetary Developments released yesterday by the Reserve Bank.

    Global Economy

  8. The global economy during the first quater of 2011 continued with the momentum of late 2010. The global manufacturing purchasing managers'' index (PMI) for February 2011 was close to a record high, while the global services PMI recorded its fastest pace of expansion in almost five years. Although these indices slipped somewhat in March 2011, they signalled continuing expansion. However, consumer confidence in major countries, which improved during January-February 2011, moderated in March 2011 on the back of higher oil prices.

  9. GDP growth in the US, which was strong at 3.1 per cent (q-o-q seasonally adjusted annualised rate) in Q4 of 2010, slipped to 1.8 per cent reflecting a decline in government spending, deceleration in private consumption and increase in imports. Clearly, a number of weaknesses persist. The US housing market remains weak. More generally, unemployment rates continue to remain elevated in major advanced economies, albeit with some improvement in the US. Concerns about sovereign debt in the euro area have now been reinforced by developments in the US. Finally, and most importantly, commodity price increases have accelerated, engendering global inflationary fears and posing downside risks to growth.

  10. The Brent crude price surged from an average of US$ 75 a barrel during May-September 2010 to US$ 123 a barrel by April 2011. The International Monetary Fund's (IMF) in its April 2011 World Economic Outlook (WEO) has assumed US$ 107 a barrel for the full year 2011. Initially, oil prices were buoyed by strong global demand and excessive liquidity. Since February 2011, oil prices have come under further pressure on account of apprehensions about supply disruptions due to political developments in the Middle East and North African (MENA) region. The demand for oil is expected to increase with the possibility of Japan substituting some of its shut-in nuclear power capacity with oil-based generation, combined with higher energy usage once reconstruction gets underway.

  11. In the recent period, commodity prices have been under pressure due to strong demand from emerging market economies (EMEs) and the financialisation of commodity markets. Global consumption of most base metals is estimated to have reached new highs in 2010. According to the Food and Agriculture Organisation (FAO), international food prices rose by 37 per cent (y-o-y) in March 2011, reflecting both higher demand and weather related supply disruptions. The increase in global food prices was led by the prices of cereals (60 per cent), edible oils (49 per cent) and sugar (41 per cent).

  12. Commodity prices are now exerting a direct impact on inflation in advanced economies, despite substantial negative output gaps. They have also accentuated inflationary pressures in EMEs, which were already experiencing strong revival in demand. While major EMEs have been tightening monetary policies for more than a year now, the European Central Bank has recently raised its policy rate - the first central bank to do so among the major advanced economies - after maintaining them at historically low levels for almost two years. Central banks in other advanced economies are also under pressure to withdraw monetary accommodation. The above trend poses appreciable downside risks to global economic activity.

    Domestic Economy

  13. The Indian economy is estimated to have grown by 8.6 per cent during 2010-11. Agricultural growth was above trend, following a good monsoon. The index of industrial production (IIP), which grew by 10.4 per cent during the first half of 2010-11, moderated subsequently, bringing down the overall growth for April-February 2010-11 to 7.8 per cent. The main contributor to this decline was a deceleration in the capital goods sector. However, other indicators, such as the manufacturing PMI, tax collections, corporate sales and earnings growth, credit off-take by industry (other than infrastructure) and export performance, suggested that economic activity was strong.

  14. According to the Reserve Bank''s Order Books, Inventories and Capacity Utilisation Survey (OBICUS), the order books of manufacturing companies grew by 7 per cent in October-December 2010 as against 9 per cent in the previous quarter indicating sustained demand albeit with some moderation. The Reserve Bank''s forward looking Industrial Outlook Survey (IOS) shows a decline in the business expectations index for January-March 2011 after two quarters of increase.

  15. Leading indicators of services sector suggest continuing growth momentum. Credit to the services sector grew by 24 per cent in 2010-11 as compared with 12.5 per cent in the previous year. Other indicators such as commercial vehicles production and foreign tourist arrivals also showed an acceleration. However, the services PMI for March 2011 showed some moderation as compared with the previous month.

  16. Inflation was the primary macroeconomic concern throughout 2010-11. It was driven by a combination of factors, both structural and transitory. Based on drivers of inflation, the year 2010-11 can be broadly divided into three periods. In the first period from April to July 2010, the increase in wholesale price index (WPI) by 3.5 per cent was driven largely by food...

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