II. Stance of Third Quarter Review of Annual Monetary Policy 2006-07

72. At the end of October 2006, i.e., at the time of the Mid-Term Review, the outlook for global growth and inflation was positive but uncertain with no definitive indications for the course of monetary policy. On the other hand, early signs of overheating in the domestic economy were recognised as too risky to ignore. Accordingly, the repo rate under the LAF was raised by 25 basis points with immediate effect on October 31, 2006 while keeping the reverse repo rate unchanged. In continuation of the stance of the Annual Policy Statement of April 2006 and the First Quarter Review of July, the Mid-Term Review of October set the stance of monetary policy for the period ahead in terms of ensuring a monetary and interest rate environment that sustains the growth momentum while securing price stability and anchoring inflation expectations. The emphasis on macroeconomic and financial stability was reinforced with a readiness to consider appropriate, immediate measures and all possible measures promptly in response to the evolving global and domestic outlook.

73. In the subsequent months, macroeconomic performance has turned out to be somewhat better than anticipated on the back of strong growth in manufacturing and services. Against this background, with a view to draining excess liquidity and pre-empting upward pressures on inflation expectations, it was decided to increase the CRR of the SCBs, regional rural banks (RRBs), scheduled state co-operative banks and scheduled primary (urban) co-operative banking system by one-half of one percentage point of their NDTL in two stages, to 5.25 per cent and 5.50 per cent, effective from the fortnights beginning December 23, 2006 and January 06, 2007, respectively. With this increase in the CRR, an amount of about Rs.13,500 crore of resources of banks was sought to be absorbed. The increase in the CRR announced on December 8, 2006 was consistent with the stance of the Mid-Term Review of October 2006 of containing inflation expectations in the current environment and consolidating gains achieved so far in regard to stability in order to sustain the momentumof growth on an enduring basis.

74. Financial markets have responded to these developments with some tightening of liquidity conditions, re-pricing and corrections in valuations. Except for the first half of December, short-term interest rates have generally risen. Contrastingly, long-term yields have declined, resulting in a narrowing of yield spreads and an inversion of the yield curve. In the credit market, buoyant deposit growth has considerably alleviated the financing constraint on the banking system. Nevertheless, both deposit and lending rates have edged up in recent months. In the foreign exchange market, sustained inflows, aided by a combination of global and domestic developments, have comfortably accommodated a modest current account deficit and have been reflected in an appreciating exchange rate. Equity markets have been driven up by strong rallies, with some intermittent corrections. The policy incentive structure for external investment is favourable to real estate and the capital market, leading to sizeable inflows and rising asset prices.

75. Real GDP growth originating from agricultural and allied activities has been somewhat lower than expected in the first half of 2006-07, based on the likely production in the kharif season. Pending a clearer assessment of the kharif crop performance and taking into account the favourable water storage conditions that should augur well for the rabi season, it is reasonable to expect that agriculture will maintain its trend growth of 3.0 per cent as anticipated in the Annual Policy Statement and the Mid-Term Review. On the other hand, the momentum of growth has been sustained in the industrial and service sectors and the outlook remains bright. Accordingly, real GDP growth for 2006-07 is currently expected to be in the range of 8.5-9.0 per cent as compared with around 8.0 per cent projected in the Mid-Term Review and 7.5-8.0 per cent in the Annual Policy Statement and the First Quarter Review.

76. Against this backdrop, the outlook for inflation assumes criticality in terms of policy monitoring and action. Prices of food articles will have considerable impact on headline inflation over the rest of the year. The seasonal decline in prices of food articles in the second half of the year has been less than normal. Prices of manufactures are firming up and were close to the headline level by the end of December, 2006. The recent initiatives by the Government of India should give comfort to the inflation outlook on account of both primary articles and manufactured products. The benefit of the reduction in prices of petrol and diesel, which came into effect in end-November, should help moderate the pressures. As regards the outlook on international crude prices, the probability of current levels being maintained is high, though some geo-political risks remain. The recent monetary policy measures, in particular, the increase in the CRR in December 2006 should work towards containing inflation expectations. On the way forward, it should be possible to build on the timely and pre-emptive actions taken so far to address issues of price stability and related expectations.

77. It is generally recognised that persistence of high inflation not only operates as a tax on the poor but also undermines economic growth and macroeconomic stability in several ways. While the objectives of monetary policy in India are growth and price stability, the relative emphasis depends on the context. In the prevailing conditions of growth, price and financial stability, unequivocal relative emphasis on stability is warranted in the current context for several reasons. High growth benefits all but the benefits to the poor accrue in a lagged fashion. While the benefits of high growth often percolate to the poor with a time lag, the impact of high prices has no such time lag and is, in fact, immediate. Furthermore, the impact of inflation is asymmetrical in our society since only about ten per cent of the work-force, which is in the organised sector, has an inflation hedge, while the rest do not have any inflation hedging mechanism.

Moreover, the adverse impact of inflation on the poor would be particularly severe if the prices of basic necessities of life increase. Hence, a determined and co-ordinated effort by all to contain inflation without unduly impacting the growth momentum is not only an economic necessity but also a moral compulsion. To the extent the current inflationary pressures are attributable to monetary conditions, it is essential to undertake appropriate measures, in continuation of those already taken and in the light of anticipated developments.