Monetary policy: Target inflation

The Reserve Bank of India has raised repo and reverse repo rates in a move to curb spiralling inflation.

As expected by most analysts, the Reserve Bank of India (RBI) raised the repo and reverse repo rates by 25 basis points (bps) each to 6.5 per cent and 5.5 per cent, respectively, as a measure to contain inflation and inflationary expectations. The review highlighted concerns on rising demand-side pressures (rapid bank credit growth, robust sales as evidence) and a spillover of food and fuel inflation to generalised inflation. Significantly, it raised its baseline projection for the Wholesale Price Index (WPI) for March by 150 bps to seven per cent.

With inflation running high, the market had braced itself for this rise, with some expecting a steeper 50-basis-point increase. However, Dun and Bradstreet Economist Arun Singh sees the calibrated rise as optimal to contain inflationary expectations without compromising on growth, given that inflation is mainly supply-side driven.

Crisil Chief Economist D K Joshi says the action is appropriate, as monetary policy isn’t quite effective in tackling food and commodity inflation, which is influenced by global factors. However, he believes, the policy will be more effective in tackling the current tight liquidity environment, with swift transmission to broader markets.

RBI reiterated the need for fiscal consolidation, focusing on quality and composition of expenditure, while referring to subsidies beyond revenue augmentation. The global recovery predicates higher fuel and commodity prices, exerting more pressure on inflation. This will impact the subsidy bill adversely, while widening the current account deficit, which RBI projects will be at an unsustainable 3.5 per cent of the gross domestic product in 2010-11.

RBI has also highlighted its concerns on the gap between the credit and deposit growth (incremental non-food credit to deposit ratio was 102 per cent in December 2010 compared to 58 per cent in December 2009), which is exacerbating tight liquidity. The central bank has suggested some moderation in the bank credit growth. Joshi expects rates to rise by another 25-50 basis points in March, given the higher WPI projection, which markets will discount going ahead.