Background:
The Reserve Bank began exiting from the crisis driven expansionary policy in October 2009. Between January 2010 and October 2011, the Reserve Bank cumulatively raised the cash reserve ratio (CRR) by 100 basis points and the policy rate (the repo rate) 13 times by 375 basis points. This monetary policy response was calibrated on the basis of India specific growth-inflation dynamics. The focus of the monetary policy stance during May-October 2011 was on containing inflation and anchoring inflation expectations even as it meant sacrificing some growth. However, in view of slowdown in growth, especially investment activity and expected moderation in inflation beginning December, it was decided to pause in the MQR of December 2011.
Since November 2011, inflation has broadly followed the projected trajectory and has shown moderation as expected. Even as inflation remains elevated, despite moderation, downside risks to growth have increased. The growth-inflation balance of the monetary policy stance has now shifted to growth, while at the same time ensuring that inflationary pressures remain contained. Accordingly, the policy stance in this review is shaped by the following three major considerations.
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First, growth is decelerating. This reflects the combined impact of several factors: the uncertain global environment, the cumulative impact of past monetary policy tightening and domestic policy uncertainties. Credit off take has also been below the projected trajectory. While slowdown in the growth of demand was the expected outcome of monetary policy actions that were taken to contain inflation, at this juncture, risks to growth have increased. This is also reflected in the scaling down of the growth projection for 2011-12 by the Reserve Bank.
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Second, though headline WPI inflation is moderating, it largely reflects a sharp deceleration in prices of seasonal food items. Inflation in respect of other key components, particularly protein-based food items and non-food manufactured products remains high. Moreover, upside risks to inflation arise from global crude oil prices, the lingering impact of rupee depreciation and slippage in the fiscal deficit.
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Third, liquidity conditions have remained tight beyond the comfort zone of the Reserve Bank. Although the Reserve Bank has conducted open market purchase of government securities to inject liquidity of over Rs. 700 billion, the structural deficit in the system has increased significantly, which could hurt the credit flow to productive sectors of the economy. The large structural deficit in the system presents a strong case for injecting permanent primary liquidity into the system.
Stance of the Current Monetary Policy
Against this backdrop, the stance of monetary policy is intended to
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Maintain an interest rate environment to contain inflation and anchor inflation expectations.
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Manage liquidity to ensure that it remains in moderate deficit, consistent with effective monetary transmission.
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Respond to increasing downside risks to growth.
Monetary Measures Taken in this policy
On the basis of current assessment and in line with the policy stance outlined in Section III, the Reserve Bank has announced the following policy measures
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Cash Reserve Ratio
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It has been decided to reduce the cash reserve ratio (CRR) of scheduled banks by 50 basis points from 6.0 per cent to 5.5 per cent of their net demand and time liabilities (NDTL) effective the fortnight beginning January 28, 2012.
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As a result of the reduction in the CRR, around Rs. 320 billion of primary liquidity will be injected into the banking system.
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Repo Rate:
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The policy repo rate under the liquidity adjustment facility (LAF) has been retained at 8.5 per cent.
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Reverse Repo Rate
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The reverse repo rate under the LAF, determined with a spread of 100 basis points below the repo rate, stands at 7.5 per cent.
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Marginal Standing Facility (MSF) Rate
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The Marginal Standing Facility (MSF) rate, determined with a spread of 100 basis points above the repo rate, stands at 9.5 per cent.
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Bank Rate
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The Bank Rate has been retained at 6.0 per cent.
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Objectives of the Current Monetary Policy:
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In reducing the CRR, the Reserve Bank has attempted to address the structural pressures on liquidity in a way that is not inconsistent with the prevailing monetary stance. In the two previous policies, it was indicated that the cycle of rate increases had peaked and further actions were likely to reverse the cycle.
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Based on the current inflation trajectory, including consideration of suppressed inflation, it is premature to begin reducing the policy rate. The reduction in the policy rate will be conditioned by signs of sustainable moderation in inflation.
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However, the persistence of tight liquidity conditions could disrupt credit flow and further exacerbate growth risks. In this context, the CRR is the most effective instrument for permanent liquidity injections over a sustained period of time. The reduction can also be viewed as a reinforcement of the guidance that future rate actions will be towards lowering them
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However, it must be emphasised that the timing and magnitude of future rate actions is contingent on a number of factors. Policy and administrative actions, which induce investment that will help alleviate supply constraints in food and infrastructure, are critical. Initiatives to narrow skill mismatches in labour markets will help ease the pressure on wages
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The anticipated fiscal slippage, which is caused largely by high levels of consumption spending by the government, poses a significant threat to both inflation management and, more broadly, to macroeconomic stability.
Expected Outcomes of the Current Monetary Policy
The policy actions and the guidance in this Statement given are expected to:
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Ease liquidity conditions.
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Mitigate downside risks to growth.
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Continue to anchor medium-term inflation expectations on the basis of a credible commitment to low and stable inflation.
Next Policies:
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The next mid-quarter review of Monetary Policy for 2011-12 will be announced through a press release on Thursday, March 15, 2012.