1. Drivers of inflation changed over the
course of 2010-11. With evidence emerging that
not only did headline inflation persist at around
9 per cent, but that it had become generalised
with significant price pressures in non-food
manufacturing since December 2010, monetary
policy was tightened more aggressively.
Following up on a series of rate hikes through
2010-11, policy rates were raised by 75 bps in
Q1of 2011-12, through a 50 bps hike in May
and 25 bps in June. Altogether, in a span of 15
months starting March 2010, operational policy
rates were raised by 425 bps – one of the sharpest
monetary tightenings seen across the world.
2. Monetary transmission improved further
during this quarter. In response to the monetary
tightening, most banks raised their deposit and
lending rates. As a result, deposit growth picked
up and credit growth decelerated, though it
remained above the projected trajectory. Also,
real lending rates remained positive despite
high inflation. These dynamics helped limit the
overheating pressures in the economy. However,
inflationary pressures have persisted due to a
series of supply-side shocks that spilled over in
the face of strong demand stoking generalised
inflation. While growth has showed some signs
of softening in Q1 of 2011-12, it is likely to stay
around the trend. Inflationary pressures are
likely to stay, if not intensify, in Q2 of 2011-12,
before moderating.
Global Economic Conditions
Recovery at risk with global growth
entering soft patch
3. Globally, the momentum of recovery
appears to be stalling. High oil and commodity prices, the Middle East political strife, Japanese
earthquake, sovereign debt problems in the Euro
zone and the impasse on the fiscal and debt
problems in the US have taken a toll on
economic activity and business as well as
consumer confidence.
4. In its June 17, 2011 update of the World
Economic Outlook, the IMF marginally
lowered its global growth projection for 2011
to 4.3 per cent from 4.4 per cent. The IMF
lowered the estimate for advanced economies
by 0.2 percentage points, but projected that
growth in most emerging and developing
economies will stay. It also retained its growth
forecast for India at 8.2 per cent at market
prices corresponding to 8.0 per cent at factor
cost.
Inflation surprise in advanced economies
increases global risks
5. Global inflation is rising rapidly. The IMF
revised its 2011 consumer price inflation
forecast for advanced economies upwards by
0.4 percentage points. There are indications that
inflation may start cooling off in some key
emerging market economies. However, the
wedge between producer price and headline
consumer price inflation, as also between the
latter and the core inflation component have
widened disconcertingly. This has triggered a
debate over how much longer advanced
economies can defer an exit from an excessively
accommodative monetary policy stance. The
ECB has already raised policy rates twice this
year, but policy dilemmas are palpable
elsewhere.
6. Unemployment is proving to be
intransigent to policy action, and with growth
relapsing amidst increasing fiscal and debt
burdens, the fragility of global recovery and its
vulnerability to macroeconomic shocks remains.
Indian Economy : Developments and
Outlook
Output
Signs of moderation after acceleration in
2010-11
7. Growth showed signs of some moderation
during Q1 of 2011-12 after it reverted to the
recent trend in 2010-11. Signs of moderation
were visible from deceleration in IIP growth in
April-May, poor performance of certain core
industries, especially cement and natural gas
and consumption deceleration in cement, steel
and automobiles. Manufacturing and services
PMIs also show that growth is turning softer.
Even as some deceleration is expected in 2011-
12, overall growth is likely to stay around trend
growth of about 8 per cent in the face of still
strong consumption demand. The monsoon may
be close to normal and services sector
momentum has been maintained.
Aggregate demand
Investment demand slows down, private
spending still strong
8. Aggregate investment dipped in H2
of 2010-11 and is yet to show signs of
improvement. Corporate investment intentions
in projects that received financial assistance
dropped by 43 per cent sequentially during the
second half of the year. Private consumption
demand remains strong but is adjusting
downwards. Corporate sales growth remained
strong during Q4 of 2010-11 and is expected
to retain the pace in Q1 of 2011-12. Profits,
however, have been impacted by margin
pressures from high interest rates and raw
material costs. A rebalancing of demand from
government consumption to private investment
is necessary in 2011-12. This rebalancing will
require shifting of government expenditure from revenue expenditure to capital
expenditure, beyond what has been envisaged
in the budget. Reduction in subsidies through
better targeting is also needed. Despite recent
initiatives to scale down subsidies, there is
likelihood of a fiscal slippage in 2011-12. In
face of decelerating investment, improved
project execution and governance can also
help in improving investment demand.
External sector
Trade diversification, invisibles turnaround
help moderate CAD
9. A significant pick-up in exports,
supported by a strategy of trade diversification
in composition and direction, and strong
software services exports, helped in moderating
the CAD during 2010-11. Going forward, CAD
is expected to remain manageable. However,
risks to current account persist from a slowdown
in global growth. Risks to capital account arise
from rising sovereign debt risks in the Euro zone
and the uncertainties on in the US debt ceiling.
10. FDI flows have picked up in 2011-12 so
far. Portfolio flows have started to rise again
since the last week of June. The inflows at the
current rate can be absorbed by the CAD, but
it is necessary to adjust the structural balance
of flows by attracting larger FDI inflows.
Monetary and Liquidity Conditions
Tight monetary and liquidity conditions
bringing desired adjustment
11. Liquidity conditions, though still in a
deficit mode, have eased during the first quarter
of 2011-12. The increase in deposit rates by
banks helped deposit growth to pick-up, which
eased the structural liquidity gap. The runaway
growth in currency has also been arrested
consequent to the rising opportunity cost of
holding cash. Reserve money growth
decelerated with low primary liquidity creation,
but monetary growth increased with
accelerating time deposit growth. Credit growth
decelerated during the quarter, but remains
above the indicative trajectory.
Financial Markets
Indian markets see range bound
fluctuations, amidst low volatility
12. Notwithstanding the firming up of interest
rates, there has been no stress visible across
the financial markets. Financial asset prices
have shown low volatility. Conditional volatility
in equity prices that had dropped significantly
after the global financial crisis continued to be
low during Q1 of 2011-12. Exchange rate
movements remained orderly obviating the need
for interventions. The yield curve flattened,
largely in response to policy rate hikes. Property
prices and volume of transactions were on the
upswing after a subdued movement in Q3 of
2010-11.
Price Situation
Generalised inflation with near-term
upside risks do not provide any comfort
13. Inflation became generalised in Q4 of
2010-11 and has remained unchanged in
trajectory as also in composition in 2011-12 so
far. This was in line with the Reserve Bank’s
projections. While some revision in fuel prices
hike was factored in the projected path of
inflation, the pass-through is yet incomplete
which will keep up the near term pressure. The
softening of global commodity prices since May
2011 may provide some relief in the short run,
but price pressures will persist as a result of a
combination of demand side factors and
structural drivers. Food inflation may not soften much even with a normal monsoon as the
increase in MSP will provide a higher floor to
food prices. Electricity prices are yet to reflect
the rising input costs. Near term trends on nonfood
manufacturing inflation will be critical in
shaping the future macroeconomic dynamics.
Macroeconomic Outlook
In the midst of downside risks to growth,
inflation stays above comfort level
14. Monetary and liquidity conditions have
remained tight in the wake of inflation
persistence. The anti-inflationary monetary
policy stance adopted by the Reserve Bank since
October 2009 continued well into the first
quarter of 2011-12 as inflation persisted beyond
Reserve Bank’s comfort level. Inflationary
pressures, which initially emanated from supply
side constraints, spilled over to wages and
output prices as demand conditions remained
buoyant. Currently, inflationary expectations
are further feeding on themselves and warrant
a close watch. While consumer demand
remains strong, higher input costs and increased
cost of borrowing are now eroding profit
margins impacting the pricing power of
corporate. On the other hand, indications of
moderation in growth have surfaced, making
the policy challenge even more complex.
However, the persisting high inflation and its
expected slow decline warrant that the Reserve
Bank continue with its anti-inflationary policy
stance.
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