Second Quarter Review of Monetary Policy 2012-13
By
Dr. D. Subbarao
Introduction
Over the last quarter, policymakers around the world have confronted increasingly difficult challenges. Globally, even as the growth momentum has slowed, governments have had to manage the balance between fiscal consolidation and growth stimulus amidst visible signs that the two objectives are in conflict with each other. As the advanced economies (AEs) deal with these tensions and global demand conditions weaken, emerging and developing economies (EDEs) are also slowing down.
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Liquidity infusions by central banks in AEs during the quarter have contributed to some stability in global financial markets. These measures cannot, however, substitute for robust structural solutions that can return the AEs to the path of recovery. At this stage, growth risks have risen and could well overwhelm the positive effects of enhanced liquidity. Moreover, with commodity prices still at elevated levels, notwithstanding some muted softening recently, risks of liquidity-driven price increases remain significant. Even as this process moves forward, the months ahead will be a period of heightened uncertainty for the global economy.
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Amidst this global slowdown and uncertainty, the Indian economy remains sluggish, held down by stalled investment, weakening consumption and declining exports. However, recent policy initiatives undertaken by the Government have begun to dispel pervasive negative sentiments. As the measures already announced are implemented and further reforms are initiated, they should help improve the investment climate further.
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Meanwhile, the persistence of inflationary pressures even as growth has moderated, remains a key challenge. In this respect, India is an exception to the global trend, which underscores the role of domestic structural factors. Of particular concern is the stickiness of core inflation, mainly on account of supply constraints and the cost-push of rupee depreciation. Consequently, managing inflation and inflation expectations must remain the primary focus of monetary policy. A central premise of monetary policy is that low and stable inflation and well-anchored inflation expectations contribute to a conducive investment climate and consumer confidence, which is key to sustained growth on a higher trajectory in the medium-term.
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Accordingly, over the past few quarters, monetary policy had to focus on inflation, even as growth risks have increased. As recent policy initiatives by the Government start yielding results in terms of revitalising activity, they will open up space for monetary policy to work in concert to stimulate growth. However, in doing so, it is important not to lose sight of the primary objective of managing inflation and inflation expectations.
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This policy review is set in the context of the above global and domestic concerns. It should be read and understood together with the detailed review in Macroeconomic and Monetary Developments released yesterday by the Reserve Bank.
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The Statement 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; and Section IV specifies the monetary measures. Part B covers Developmental and Regulatory Policies and is organised in six sections: Interest Rate Policy (Section I); Financial Markets (Section II); Financial Stability (Section III); Credit Delivery and Financial Inclusion (Section IV); Regulatory and Supervisory Measures (Section V); and Institutional Developments (Section VI).
Global Economy
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Notwithstanding modest improvement in growth performance in parts of the world in Q3 of 2012, the global economy remains sluggish. In the US, growth in Q3 picked up relative to the earlier quarter. In the UK, after three consecutive quarters of contraction, growth turned positive in Q3. The euro area continued to experience contraction in output in Q2, and recessionary headwinds have persisted in Q3. Growth decelerated significantly in Japan. High unemployment relative to trend persisted in all major AEs, although in September the US unemployment rate declined to below 8 per cent for the first time in four years. As regards the other BRICS -- Brazil, Russia, China and South Africa -- they have also slowed in the first half of 2012, with China decelerating further in Q3. Reinforcing this perspective, the average level of the global composite PMI for Q3 remained nearly unchanged from the three year low in the previous quarter.
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In September, additional quantitative easing measures were announced by the US Fed, the European Central Bank and the Bank of Japan to which financial markets responded positively as reflected in the prices of risky assets and narrowing of spreads. According to the October 2012 Global Financial Stability Report of the IMF, however, risks to financial stability have increased since April as confidence in the global financial system remains fragile, notwithstanding greater monetary accommodation by central banks.
Domestic Economy
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The loss of growth momentum that started in 2011-12 has extended into 2012-13 though the pace of deceleration moderated in Q1. Nevertheless, growth remains below trend and persisting weakness in investment activity has clouded the outlook.
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After decelerating over four successive quarters from 9.2 per cent y-o-y in Q4 of 2010-11 to 5.3 per cent in Q4 of 2011-12, GDP growth was marginally higher at 5.5 per cent in Q1 of 2012-13. The slight improvement in GDP growth in Q1 of 2012-13 was mainly driven by growth in construction, and supported by better than expected growth in agriculture.
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On the expenditure side, the growth of gross fixed capital formation decelerated from 14.7 per cent in Q1 of 2011-12 to 0.7 per cent in Q1 of 2012-13. The slowdown in growth of private consumption expenditure witnessed during Q4 of 2011-12 continued through Q1 of 2012-13. External demand conditions and crude oil prices have also remained unfavourable, adversely impacting net exports.
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After declining for two consecutive months, the index of industrial production (IIP) posted a modest growth of 2.7 per cent in August. The upturn was visible in mining and manufacturing sectors. However, over the period April-August, industrial activity was lacklustre at 0.4 per cent as against 5.6 per cent during the corresponding period last year. Most significantly, reflecting the retrenchment of investment demand, capital goods production declined by 13.8 per cent during April-August.
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The seasonally adjusted manufacturing PMI in September was unchanged relative to its August level, but was below its level in June. The headline services business activity index, seasonally adjusted, was marginally higher in September than in August.
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Notwithstanding apprehensions earlier in the season, rainfall deficiency during the south-west monsoon was 8 per cent of the long period average (LPA). However, the uneven temporal and spatial distribution of the monsoon this year is expected to adversely impact the Kharif output. According to the first advance estimates, production of Kharif foodgrains at 117.2 million tonnes (MT) in 2012-13 will be lower by 9.8 per cent than the record output in the previous year.
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According to the Reserve Bank''s order books, inventories and capacity utilisation survey (OBICUS), capacity utilisation of the manufacturing sector in Q1 of 2012-13 declined from the preceding quarter and a year ago. For Q2, business confidence, as measured by the business expectations index of the Reserve Bank''s industrial outlook survey (IOS), dipped relative to the previous quarter.
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Headline WPI inflation remained sticky at above 7.5 per cent on a y-o-y basis through the first half of 2012-13. Furthermore, in September there was a pick-up in the momentum of headline inflation, driven by the increase in fuel prices and elevated price levels of non-food manufactured products. While this is in part attributable to some suppressed inflation in the form of earlier under-pricing being corrected, even after this, the momentum remains firm.
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Even while y-o-y inflation of WPI primary food articles moderated since July due to the softening of prices of vegetables, prices of cereal and protein-based items such as pulses, eggs, fish and meat edged up. WPI food products inflation increased in September, mainly due to the firming up of the prices of sugar, edible oils and grain mill products.
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Fuel group inflation registered a significant rise in September, primarily due to the WPI reflecting the sharp increase in prices of electricity effected from June, the partial impact of the increase in prices of diesel in mid-September and significant increase in non-administered fuel prices on account of rising global crude prices.
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Non-food manufactured products inflation was persistent at 5.6 per cent through July-September and continued to exhibit upside pressures from firm prices of metal products and other inputs and intermediates, especially goods with high import content due to the rupee depreciation. The momentum indicator of non-food manufactured products inflation (seasonally adjusted 3-month moving average annualised inflation rate) also remained high.
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The new combined (rural and urban) CPI (Base: 2010=100) inflation remained elevated, reflecting the build-up of food price pressures. CPI inflation excluding food and fuel groups ebbed slightly during June-September, from double digits earlier. Inflation based on the CPI for industrial workers recorded an upturn, primarily due to higher food inflation. The y-o-y increase in rural wages, though showing some moderation, has remained high.
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Reflecting some softening in inflation from the high levels observed in the...
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