Besides oil prices, there are some underlying inflationary pressures impacting inflation in India. Inflation, based on variations in the wholesale price index (WPI) on a year-on-year basis, increased to 11.05 per cent as on June 7, 2008 from 7.75 per cent at end-March 2008 and 4.28 per cent a year ago. Excluding the fuel sub-group, inflation rose to 9.61 per cent from 5.92 per cent a year ago. Excluding fuel and food, inflation was 10.33 per cent as against 6.33 per cent in the corresponding period of the preceding year. inflation based on the consumer price index (CPI) for industrial workers (IW) and urban non-manual employees (UNME) stood at 7.81 per cent and 6.99 per cent, respectively, on a year-on-year basis in April 2008 as compared with 6.67 per cent and 7.74 per cent a year ago. Inflation based on CPI for agricultural labourers (AL) and rural labourers (RL) stood at 9.11 per cent and 8.84 per cent in May 2008, respectively, as compared with 8.22 per cent and 7.90 per cent a year ago. Therefore, it is important to recognise that an adjustment of overall aggregate demand on an economy-wide basis is warranted to ensure that generalised instability does not develop and erodes the hard-earned gains in terms of both outcomes of and positive sentiments on India's growth momentum.

This calibrated approach on an ongoing basis and in a timely manner draws upon the lessons from managing these challenges in the recent period. Graduated monetary policy actions undertaken since September 2004 to withdraw monetary accommodation have successfully moderated signs of overheating that emerged in 2006-07 and continue to have some stabilising influence on the economy. Supply management strategies undertaken by the Government of India are also working through the economy.

However, on a year-on-year basis, money supply (M₃) increased by 21.4 per cent as on June 6, 2008 over and above the growth of 21.0 per cent a year ago and well above the indicative projection of 16.5-17.0 per cent set for 2008-09 in the Annual Policy Statement of April 2008. Similarly, reserve money increased by 28.5 per cent on June 13, 2008 as compared with 24.6 per cent a year ago. Aggregate deposits rose by 23.2 per cent on a year-on-year basis on June 6, 2008 which is above the indicative projection of 17.0 per cent for 2008-09. Non-food credit growth was 26.2 per cent and was also above the indicative projection of 20.0 per cent.

At this juncture, the overriding priority for monetary policy is to eschew any further intensification of inflationary pressures and to firmly anchor inflation expectations. Several positive factors that currently exist need to be recognised. Relative to several other emerging economies, the Indian economy has, by and large, a reasonable supply-demand balance which provides some insulation in managing this unprecedented shock from global oil markets. Domestic financial markets and institutions have been largely secured against the contagion from the unsettled conditions in international financial markets. Furthermore, India is somewhat de-coupled from the intensifying global food crisis in view of the improvement in domestic agricultural performance. The external sector is strong and resilient with modest current account deficits relative to the size of the economy and has a comfortable level of foreign exchange reserves. Accordingly, the major focus of public policy at the current juncture needs to be on dealing with the impact of the escalation of international crude prices in a well-managed and smooth adjustment that draws on demonstrated strengths and positive outcomes. Moderating and managing aggregate demand so that pressures on prices are not intensified is a critical element of this approach.

In this regard, monetary policy has to urgently address aggregate demand pressures which appear to be strongly in evidence. First, inflation has increased to a 13-year high and inflation expectations have been driven up by unrelenting pressures from international commodity prices, particularly crude and metals. Second, investment demand continues to be strong, growing in the range of 14-19 per cent annually since 2002-03 and currently constituting 36 per cent of GDP. This is also reflected in the pick-up in the growth of domestic capital goods production in April 2008 after some deceleration in January-March. Furthermore, consumption demand appears to be reviving the production of consumer goods, with a turnaround in the production of durables. Third, with merchandise imports running ahead of exports, the trade deficit widened sizeably in 2007-08 and has continued to expand in April 2008. Although large oil imports appear to be the main driver, non-oil imports have also increased at a considerable pace, contributing more than 60 per cent of the overall import growth in April 2008 and reflecting the pressure of domestic demand. There has also been some tightening of external financing conditions in the ongoing global financial turmoil. Fourth, fiscal pressures are emerging due to the possibility of enhanced subsidies on account of food, fertiliser and POL as well as for financing deferred liabilities relating to farm loan waivers with implications for additional pressures on aggregate demand, and with potential spillovers into the external sector.

The overall stance of monetary policy in 2008-09 was set in terms of ensuring a monetary and interest rate environment that accords high priority to price stability, well-anchored inflation expectations and orderly conditions in financial markets while being conducive to continuation of the growth momentum with due emphasis on credit quality and credit delivery. It was resolved to respond swiftly on a continuing basis to the evolving constellation of adverse international developments and to the domestic situation impinging on inflation expectations, financial stability and growth momentum, with both conventional and unconventional measures, as appropriate.

Consistent with the stance of monetary policy as set out above and on the basis of incoming information on domestic and global macroeconomic and financial developments, it has been decided to take the following measures:

(a) The repo rate under the Liquidity Adjustment Facility (LAF) is increased from 8.00 per cent to 8.50 per cent with immediate effect.

(b) The cash reserve ratio (CRR) of the scheduled commercial banks, regional rural banks (RRBs), scheduled state co-operative banks and scheduled primary (urban) co-operative banks is being increased by 50 basis points to 8.75 per cent in two stages, effective from specified fortnights as indicated below:

In view of the criticality of anchoring inflation expectations, a continuous heightened vigil over ensuing monetary and macroeconomic developments is warranted to enable swift responses with appropriate measures as necessary, consistent with the monetary policy stance.

Alpana Killawala
Chief General Manager