The central bank now expects GDP growth in FY14 to come in at levels close to the 5% seen last fiscal. Any formal revision of forecasts, however, will be announced on Tuesday, when the RBI meets to review monetary policy. In this milieu, monetary and fiscal policies will have to be crafted so as to allow structural policy measures and ground-level actions to shape a sustainable recovery by next year, the RBI noted, saying it had the unenviable task of anchoring inflation expectations at a time when growth remains tepid.
Economists expect the central bank to hike its key policy repo rate by 25 basis points to 7.75% on Tuesday while lowering the marginal standing facility (MSF) rate by 25 basis points to 8.75%. Banks are currently allowed to borrow 0.5% of their deposit base through the liquidity adjustment facility (LAF) window. For additional requirements, they must access the MSF window.
The tone of the review remains hawkish, which means inflation and inflationary expectations will be the focus of the policy, said Shubhada Rao, chief economist at Yes Bank. Rao expects a 25 basis points hike in the repo rate and does not rule out further rate hikes.
Price stability seems to be the key objective for the RBI, said Saugata Bhattacharya, chief economist at Axis Bank.
Bhattacharya does not expect the RBI to lift the cap on LAF borrowings though he believes the central bank may allow banks to borrow more through the term repo operations, a move that would help the market develop.
In its annual policy in May, the central bank had put out a baseline GDP growth forecast of 5.7% for FY14, which was lowered to 5.5% in July. Meanwhile, a professional forecasters' survey conducted by the RBI pegs growth for FY14 at 4.8% versus an earlier forecast of 5.7%.
After a slower H1, a modest recovery is likely in H2 of 2013-14. This is expected to come from a rebound in agricultural growth backed by a better than normal southwest monsoon and a pick-up in exports, the RBI said.
Even as growth impulses remain weak, inflation pressures have re-emerged in the economy, leaving the central bank in a tight spot. The RBI expects inflation to remain range-bound in the second half of the fiscal year near current levels, which suggests that the central may be forced to raise its year-end projection of 5% for wholesale inflation. Wholesale price inflation rose 6.46% in September while consumer price inflation stood at 9.84%.
While the RBI acknowledges that inflation in primary food articles and a significant rise in vegetable prices during the first half of the year have been the driving factors behind the rise in inflation in recent months, it appears concerned about the rise in inflation expectations and the possible generalisation of inflation pressures.
Pending sufficient supply responses, it is important that monetary policy keeps a tight leash to prevent relative price shocks in the current year from getting generalised, it said.
The RBI also cited the latest round of its inflation expectations survey, which indicated that inflation expectations for the next three months and the next one year have both moved up in the last quarter.
The RBI may also continue to keep a tight leash on liquidity as a result of persisting inflation concerns. Drawing a comparison between India and its emerging market peers, the RBI concluded that India has faced markedly higher levels of inflation in recent years.
This makes it important to keep liquidity under check and the policy rate at a reasonable level to anchor inflation expectations, with a view to ensuring stable macro-financial conditions and positive real returns to savers, concluded the central bank. As the exceptional measures are rolled back with the improvement in exchange market conditions, it is important to keep this balance in view.
The RBI has capped bank borrowings at the repo rate from the LAF in July in response to the sharp depreciation in the rupee. The RBI had also hiked the MSF rate to 10.25%.
The RBI recently introduced 7-14 day term repo operations and allowed banks to borrow 0.25% of system-level deposits from these windows. Market players expect the RBI to allow higher borrowings via term repos in order to help develop that market.
Interesting, the rupee and the current account deficit, which until last quarter were the primary concerns for the RBI, have taken a back seat to price pressures. The central bank noted that external sector risks have reduced as the current account deficit is likely to moderate starting the second quarter of 2013-14.
The trade balance has responded to the policy measures taken; exports have picked up and gold imports have declined, the central bank said.
Indias CAD widened from 3.6% of GDP in the fourth quarter of 2012-13 to 4.9% of GDP in the first quarter of 2013-14
The central bank also acknowledged that pressures on the currency have abated for the time being although it said that uncertainties about future event shocks remain.
The RBI has also been trying to boost reserves through two special swap facilities introduced in early September. The swap facility for FCNR(B) deposits and bank overseas borrowings drew in $6.9 billion and $ 4.4 billion, respectively, till October 25, according to the RBI. The windows will remain open till November 30.