In the first quarterly monetary policy review of 2010-11, the balance of policy stance has shifted emphatically from nurturing growth to containing inflation and inflationary expectations. As stated by the Reserve Bank, the current stance of monetary policy is to:
Contain inflation and inflationary expectation
Maintain an interest rate regime consistent with price, output and financial stability.
Actively manage liquidity to ensure that it remains broadly in balance so that excess liquidity does not dilute the effectiveness of policy rate action.
Policy action:
Effective
Mkt. Expectation
Effective Level
Repo
25 bps
25 bps
5.75%
Reverse Repo
50 bps
25 bps
4.50%
CRR
Unchanged
Unchanged
6.00%
Key takeaways Economic Growth
Growth prospects for the economy have improved. GDP growth forecast revised upwards from 8.00% to 8.50%.
Domestic drivers of growth are robust and there is conviction that domestic economic recovery is firmly in place and is strengthening.
A good monsoon should help in a pickup of rural demand.
Inflation
Policy statement and action shows intent to decisively contain inflation and anchor inflationary expectations. The baseline projection for WPI inflation for March 2011 has been raised from 5.50% to 6%.
Inflationary pressures have exacerbated and have become more generalised, with demand side pressures evident.
The factors likely to influence the future path of inflation include monsoon, energy prices and demand side pressures.
Capacity utilization is high in various sectors and demand is exerting pressure on prices.
Policy rate and stance has to reflect this domestic scenario of high growth and high inflation which is in contrast with most of the developed countries.
Liquidity
RBI has pointed out that transmission of monetary action is most effective when liquidity is being injected into the financial system by the central bank rather than when it is being absorbed. Ideally RBI would like to see tight liquidity to contain demand, but that can result in reduction of credit to productive sectors. Therefore we are likely to shift from a uni-directional surplus mode to a bi-directional mode with overnight rates frequently at both ends of the LAF corridor. As this is likely to increase volatility in money market rates the reserve bank has reduced the corridor between repo and reverse repo rates.
Additional measures
Introduction of a Mid-Quarter review of monetary policy, which will be announced through a press release.
Setting up of a working group to review current operating procedure of monetary policy of the reserve bank, including LAF.
Our View
Reverse repo 5.25% and repo rate of 6.25% by end of CY 2010.
Money market rates to remain volatile as call rates oscillate between reverse repo and repo rates.
Gradual upward shift of the term structure and flattening of the yield curve.
RBI’s preference for tighter liquidity as stated in the policy review should translate into tighter liquidity going forward.
Disclaimer:-
The contents of this article represent the opinions of our research team. Nothing contained herein is intended as investment advice or recommendations for specific investment decisions, and you should not rely on it as such. Information and analysis above are derived from various sources and using methods believed to be reliable, but we do not assume responsibility and liability for any consequence of the investment decision taken by you based on this analysis. Investment decision taken by readers to this article will be at their sole discretion. The purpose of this article is intended to be used as an educational discussion of the issues involved. This is not to be construed as a solicitation to buy or sell securities.
