Inflation is a concern

MONETARY POLICY MID-TERM REVIEW 2006-07

VIEWPOINT: A.K.Sridhar, ED & CIO, UTI MF.

Overall our assessment of the policy is one that is largely neutral with a negative bias for the markets. The RBI has hinted at being more "pro-reform" than in the past and less of an inflation hawk in this mid-term review of the Annual Policy Statement announced today.

Further, our view is based on the fact that the favourable base effect of inflation is likely to wear out by the end of November. And with commodity prices remaining strong the inflationary expectations would tend to build up.

Also, with the commencement of the busy season, systemic liquidity could possibly dry up and hence leave the RBI with little choice but to tighten its policy stance in/or ahead of its January policy review.

In the short term, this could tend to result in an upward bias on the yields and hence the benchmark 10year security yield range of 7.60% to 8.00% seems a distinct possibility by Jan'07 from the level of 7.64% that it currently trades at.

The RBI raised only the repo rate by 25bps while keeping intact the more critical reverse repo rate at 6%. It also kept the bank rate and CRR unchanged at 6% and 5% respectively.

In addition, it has sounded warnings of early signs of overheating in certain sectors of the credit market such housing, commercial and retail loans, including personal loans.

It has stated that inflationary pressures have eased (notwithstanding the seasonal spike in wheat prices), on account of expansion of productive capacity and cooling crude oil prices; but would need to be monitored carefully. The average annual rate of inflation for FY07 stood at 4.5% as on 14th October 2006, while it was measured at 5.3% a year ago.

However the positive/favourable base effect of last year is likely to wear off in the coming months and this could amplify measured inflation by the close of FY07. This coupled with uncertain crude oil outlook and continued demand side pressures could build up inflationary expectations in the market.

GDP target has been revised upwards to 8% from 7.5-8% on account of stronger than expected growth momentum even as the RBI admitted that the annual targets of M3 (below15%) and credit growth (20%) were likely to be surpassed. However, annual inflation target has been maintained at 5-5.5% range.

To support export and investment demand, reinforce price stability and anchor inflationary expectations. Maintain emphasis on macroeconomic and financial stability, and to consider promptly all possible measures to evolving global and domestic environment.