Second Quarter Review of Monetary Policy 2011-12


From a macroeconomic perspective, the last quarter witnessed significant developments, both globally and domestically. Growth momentum in the US and the euro area economies has weakened. In the euro area, macroeconomic prospects are intimately tied in to its ability to credibly resolve its sovereign debt and financial sector problems. In turn, trade and financial linkages increase the risks of euro area instability transmitting through to emerging market economies (EMEs), which have already experienced large volatility in their financial markets, particularly their currency markets. Significantly, while the prices of many commodities declined over the quarter, crude oil prices remained relatively firm. The impact of this on commodity importing EMEs has been exacerbated by currency depreciation.

  1. Amidst this turbulence and heightened uncertainty, the Indian economy is clearly seeing slowing growth. This moderation is, in part, due to the anti-inflationary stance of monetary policy, a necessary pre-condition to bring inflation down. But there are also other factors responsible for the moderation in growth, particularly for the significant slowdown in investment activity, such as policy and regulatory matters. These issues clearly have adverse implications for sustaining rapid growth.

  2. Of larger concern is the fact that even with the visible moderation in growth, inflation has persisted. Reassuringly, momentum indicators are turning down, consistent with the Reserve Bank''s projections that inflation rate will decline significantly in December and continue on that trajectory into 2012-13.

  3. The policy stance and guidance in this Review are shaped by the need to balance concerns about persistent inflation and moderating growth. Recent policy actions have been firmly based on the proposition that sustained growth over a long period of time is compatible only with low and stable inflation. Persistently high inflation strongly influences expectations adversely and, through them, consumption and investment decisions. Changing the policy stance when inflation is still far above the tolerance level entails risks to the credibility of the Reserve Bank''s commitment to low and stable inflation. However, growth risks are undoubtedly significant in the current scenario, and these need to be given due consideration.

  4. 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 releasedyesterday by the Reserve Bank.

  5. This 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 for Commercial Banks (Section V) and Institutional Developments (Section VI).

    Part A. Monetary Policy

    I. The State of the Economy

    Global Economy

  6. Economic activity in advanced economies weakened further during Q3 of 2011 (July-September). Escalating concerns over medium-term sovereign debt dynamics in the euro area and, in particular, substantial potential losses to banks holding this debt have impacted global financial markets enormously. The adverse feedback loops among sluggish growth, weak sovereign balance sheets, large exposures of banks to sovereign debt and political compulsions coming in the way of a credible solution have created a crisis of confidence, which is a potential threat to regional and global financial stability.

  7. High prices of crude oil and other commodities, persistently high unemployment and weak housing markets continued to impact consumer confidence and private consumption. Fiscal tightening, driven by medium-term sovereign debt concerns, also contributed to the loss in the growth momentum. This is reflected in the fall in the global manufacturing purchasing managers'' index (PMI) to 49.9 in September, its lowest level since June 2009.

  8. The above factors also had a knock-on impact on major EMEs. According to the IMF, global growth decelerated from 4.3 per cent year-on-year (y-o-y) in Q1 of 2011 to 3.7 per cent in Q2, and further to an estimated 3.6 per cent in Q3, as growth in advanced economies fell from 2.2 per cent to 1.5 per cent and 1.3 per cent over the same period.

  9. Significantly, the weaker global growth since Q2 has resulted in only a small correction in international commodity prices, particularly crude oil. Brent and Dubai Fateh prices (which comprise the Indian basket) have declined only modestly. The World Bank''s September 2011 indices of energy prices were higher by 32 per cent (y-o-y) and of non-energy by 17 per cent.

  10. Reflecting the above trend, headline measures of inflation remained above the comfort zones/targets in both advanced economies and EMEs. In the case of EMEs, strong domestic demand pressures added to inflationary pressures. Amongst major economies, headline consumer price inflation (y-o-y) in September 2011 was 3.9 per cent in the US, 3.0 per cent in the euro area, 5.2 per cent in the UK, 6.1 per cent in China, 7.3 per cent in Brazil and 6.2 per cent in Turkey. In response to turbulent global conditions and domestic considerations, central banks in major EMEs have displayed a variety of responses, depending on their specific macroeconomic conditions.

    Domestic Economy

  11. GDP growth decelerated to 7.7 per cent in Q1 (April-June) of 2011-12 from 8.8 per cent a year ago, and 7.8 per cent in Q4 of 2010-11. From the supply side, the deceleration in growth in Q1 was mainly due to slower growth in mining, manufacturing, construction and ''community, social and personal services''.

  12. Rainfall during the south-west monsoon was one per cent above normal. The Reserve Bank''s production weighted rainfall was also one per cent above normal. The first advance estimates for the 2011-12 kharif season point to record production of rice, oilseeds and cotton. However, the output of pulses may decline due to a reduction in acreage.

  13. Industrial growth, as measured by the index of industrial production (IIP), decelerated to 5.6 per cent during April-August 2011 from 8.7 per cent in the corresponding period of the previous year. This was mainly on account of slowdown in capital goods, intermediate goods and consumer durables. Growth of eight core infrastructure industries during April-August 2011 also slowed down to 5.3 per cent from 6.1 per cent in the corresponding period of last year.

  14. According to the Reserve Bank''s order books, inventories and capacity utilisation survey (OBICUS), capacity utilisation moderated during Q1 of 2011-12 compared with the previous quarter. Business sentiment, as indicated by the business expectations index of the Reserve Bank''s industrial outlook survey, declined in Q2 of 2011-12 and showed further moderation for the following quarter. PMI indices for both manufacturing and services declined during September 2011.

  15. Based on an analysis of a sample of 2,426 non-financial companies, margins of corporates in Q1 of 2011-12 moderated across sectors compared with their levels in Q4 of 2010-11. A classification of companies into the use-based segments of the IIP indicated that the intermediate goods segment registered the maximum decline in margins, reflecting the impact of commodity prices. Other segments saw lower margin compression, suggesting that pricing power was reducing, albeit gradually. Early results for Q2 of 2011-12 (of 161 companies analysed till October 20, 2011) suggest that both sales growth and margins moderated marginally.

  16. Y-o-Y headline WPI inflation has remained stubbornly high during the financial year so far, averaging 9.6 per cent. Inflation was driven by all the three major groups, viz., primary articles; fuel and power; and manufactured products. As indicated in the First Quarter Review, both the level and persistence of inflation remain a cause of concern. However, there is some comfort coming from de-seasonalised sequential quarterly WPI data which suggest that inflation momentum has turned down.

  17. Y-o-Y primary food inflation was 9.2 per cent in September 2011 as compared with 9.6 per cent in August. The elevated level of primary food inflation was mainly on account of increase in prices of vegetables, milk and pulses.

  18. Y-o-Y fuel-group inflation increased from 12.8 per cent in August 2011 to 14.1 per cent in September mainly due to the increase in petrol prices and upward revision in electricity prices.

  19. Y-o-Y non-food manufactured products inflation was 7.6 per cent in September as compared with 7.7 per cent in August; it was 7.0 per cent in April. This should be seen in comparison with the average non-food manufactured product inflation of a little over 4.0 per cent during the last six years. The current high level reflects a combination of high commodity prices and persistent pricing power as evidenced from the early corporate results of Q2 of 2011-12.

  20. Y-o-Y inflation as measured by the consumer price index (CPI) for industrial workers, which had moderated during April-July 2011, rose to 9.0 per cent in August reflecting increase in food prices. The new combined (rural and urban) CPI (Base: 2010=100) rose to 113.1 in September from 111.7 in August. Inflation based on other CPIs was in the range of 9.3 to 9.4 per cent during September.

  21. Y-o-Y money supply (M3) growth moderated from 17.2 per cent at the beginning of the financial year to 16.2 per cent on October 7, 2011. This level...

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