Managing inflation to be policy focus: RBI

In an indication of further tightening of monetary policy, the Reserve Bank of India's (RBI) pre-policy report said that managing inflation and inflationary expectations will be the dominant theme of monetary policy management in 2010-11.

In the "Macroeconomic and Monetary Developments in 2009-10", RBI said the growth outlook for the economy remains positive in the near term, though recovery in private demand needs to be stronger.

"It is likely that the growth impulses could further strengthen during 2010-11, and therefore, anchoring inflationary expectations without hurting the growth process continue to be the focus of monetary policy," the central bank said in the report on the eve of its Annual Policy Statement for 2010-11, which is due to be released tomorrow.

Despite the all-round improvement seen across agriculture, industry and services, RBI warned of monsoon-related uncertainty. Besides, it said that downside risks arose from a fragile global recovery and a decline in the domestic savings rate, led by a decrease in public sector savings.

The report went on to add that high inflation could dampen recovery in growth. While the pace of increase in prices was expected to moderate in the next few months, RBI warned that the rise in international commodity prices, especially crude oil could pose a risk.

In addition, it said that a revival in private consumption demand and the bridging of the output gap could add to the inflationary pressure. Further, it warned against hardening of inflationary expectations.

Inflation based on the wholesale price index was estimated at 9.9 per cent at the end of March. A survey of professional forecasters indicated that it could average at 7 per cent in the current financial year, against an earlier estimate of 6.1 per cent. The forecasters' survey also provided comfort to RBI on economic expansion with a median estimate of 8.2 per cent for 2010-11, as against the earlier projection of 7.9 per cent (see table).

Broadly, RBI's Industrial Outlook Survey too brought out similar optimism though the expectations in the first quarter of the current financial year showed some moderation compared to the fourth quarter of the last financial year. The central bank, however, said that that was partly due to seasonality.

The survey showed that a slowdown in demand was expected during April-June along with a decline in the availability of finance. At the same time, profit margins are expected to increase and as a sign on gradual return of pricing power, selling prices are expected to increase at a higher rate.

"While elevated headline inflation and the recovery in growth could increase the demand for money, policy driven increase in CRR (cash reserve ratio) could contribute to containing the growth in broad money," the report said.

The market widely expects the central bank to increase the policy rates – repo and reverse repo – and further tighten liquidity by raising the cash reserve ratio. Banks today parked Rs 28,845 crore through the central bank's reverse repo window, which is used to park excess cash with banks.

RBI also acknowledged the prospects on an increase in net capital inflows on account on higher growth prospects as also larger interest rate differentials between India and the advanced economies. "Like other EMEs (emerging market economies), however, higher capital inflows could influence asset prices, domestic liquidity conditions and the exchange rate. This will have implications for monetary management," the central bank said.

So far in 2010, foreign institutional investors have pumped in Rs 48,158 crore in the Indian equities and debt markets resulting in the Indian currency gaining 4.05 per cent against the US dollar. The rupee closed at 44.73 against the greenback today, compared to 46.62 on January 1.

With RBI expected to resort to further monetary tightening, portfolio flows are projected to rise further, resulting in more pressure on the rupee.