A brief review of monetary policy of RBI

RBI announced its mid-quarter review of monetary policy today. The central bank has increased the repo rate by 25bps to 8.25% with immediate effect. With this increase, the operating policy rate is higher by 500 bps since the beginning of RBI’s current rate hike cycle.

Stance of Monetary Policy:

RBI has re-iterated its anti-inflationary stance. RBI stated that it is imperative to persevere with the current anti- inflationary stance since a premature change in policy stance could risk hardening inflationary expectations.

The tone of the monetary policy commentary however, appears much less hawkish compared to the previous policy. 

On the growth front, GDP decelerated to 7.7% in Q1FY12 from 7.8% in Q4FY11 and 8.8% in Q1FY10. IIP too posted a severe slowdown to 3.3% in July from 8.8% year ago. 

Monsoon so far has been normal.

The first advance estimates for 2011-12 kharif season point to a record production of rice, oilseeds and cotton, while the output of pulses may decline. In the next quarterly review, RBI is likely to revise its FY12 GDP forecast of 8% downwards to 7.7%-7.8% levels.

RBI remains concerned on potentially adverse global macroeconomic developments.

Inflationary pressures on account of persistent food inflation and some elements of fuel inflation will continue to keep headline inflation higher. 

However, going forward, demand-side inflationary pressures are seen moderating on account of several factors such as cumulative impact of past policy actions, improved monetary transmission levels and moderating growth momentum.

Given that non-food manufacturing inflation (which is closely tracked by RBI as a measure of core inflation) has a higher weightage in WPI as well as limited ability of monetary policy to address structural food demand-supply imbalances, the repo rate appears to be close to peak levels. 

While RBI may keep some buffer for possibly another hike in case demand impulses do not act as per expectations in the latter part of this fiscal, it is also widely expected that, in case of any potential external shocks, RBI would move swiftly and choose to focus on financial stability versus inflation.

Outlook: 

RBI stance of monetary action will continue to be based on the inflation trajectory going ahead as well as the trends in global macro-economic scenario.

 We expect an average WPI inflation of ~8.5% during FY12 and FY12 GDP at ~7.75%. Another 25 bps hike is not ruled out during FY12. The steady pace of monetary tightening last year has resulted in moderating capex and investment demand.

A sustained continuation of previous, current and future monetary transmission into higher lending rates could affect both consumption and investment demand, with lagged impact of the same spilling over into FY13 as well.