RBI addresses liquidity concerns; keeps key policy rates and inflationary expectations firmly anchored

Responding to an acute and prolonged liquidity crunch, the RBI in its recent Review of Monetary Policy has reduced the CRR (Cash Reserve Ratio, the amount of cash that banks have to mandatorily park with it) by 50 basis points from 6 per cent to 5.50 per cent of deposits, infusing about Rs. 32,000 crore into the banking system to mitigate the effects of net liquidity drainage from the system. For the last 4-5 months, commercial banks put together were borrowing Rs. 1-1.5 lakh crores on a daily basis from RBI. Since mid-October 2011, pressures on liquidity were acute despite injection of liquidity worth Rs. 70,000 crore, exacerbated by the forex market operations conducted by the Reserve Bank in response to a sharp depreciation of the Indian currency. This is indeed a reversal of the central bank’s policy stance as RBI notes that it considers the CRR as a monetary policy instrument with liquidity dimensions. However, RBI held its key policy rates unchanged (Repo: 8.5%, Reverse Repo 7.5% and MSF at 9.5%; SLR at 24.0%).

The country’s central bank’s decision making has turned even more challenging in recent months as the global economic scenario has worsened with Europe’s debt crisis pulling down growth and trade estimates across the globe. India’s domestic investment has also been on a downturn posing risk to future growth and has partially showed up in latest GDP as well as IIP numbers, leading to significant lowering of growth forecasts; the RBI has also slashed its growth forecast for the current fiscal from 7.6 per cent predicted in October to 7 per cent. Price pressures on the other hand have shown signs of moderating with lower pace of increase in the WPI in recent months, lower financial year build-up of inflation and dampening month-over-month seasonally adjusted annualised (3 month moving average) rate of inflation. However, the RBI’s commitment to a reversal in key policy rates is restricted by certain issues in inflation trends; the sharp decline in primary food inflation reflects high base and seasonal moderation together with moderation in global food prices with the FAO Food Price Index in December 2011 about 13 percent below its historical peak in February 2011. The RBI rightly feels that the comfort may fade fast if policy and administrative actions, which encourage investment that will help ease supply constraints in food and infrastructure, are not forthcoming and if the anticipated fiscal slippage, which is caused largely by high levels of consumption spending by the government and poses a significant threat to credible inflation management, is not adequately addressed.

RBI’s recent policy measure has been greeted well by markets, industry and analysts alike. Going forward, though the RBI’s bias is now stated to be doveish, the timing of the rate reversal cycle remains difficult to predict as it would clearly depend on inflationary trends; global inflation is likely to be moderating given the fiscal austerity driven demand deficiency around the globe, but domestic price pressures may yet resurge through either rupee depreciation, energy price pass-throughs or any expansionary (consumption demand augmenting) measures taken by the government without adequately addressing supply-side issues. The government’s response in the forthcoming budget is to be watched, however, whatever measures are announced would take some amount of time and will to execute. Thus the waiting and watching continues.

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