Outlining the challenges for the economy post the financial meltdown, it has also said the governments fiscal policy must include rationalisation of expenditure. It has cautioned that though reverting to the high-growth trajectory at the earliest remains the key policy challenge in the near to medium-term, the sustained expansionary fiscal and monetary policy stances, run the risk of making inflation peak in the medium-run.
Timely exit from the current policy stance, thus, would be critical, given the emerging signs of inflationary pressures, said RBI in its Annual Report 2008-09 released on Thursday.
Moreover, deficient monsoon and its possible adverse effects on agricultural output may not only put pressure on food prices, but also increase the demand for more subsidies and relief measures.
The pressure on the fiscal situation could only increase if drought-related policy response involves further expansion in government expenditure, and the additional costs associated with possible import of essential commodities to improve domestic supply conditions.
Given the fact that food prices remaining high, despite low overall WPI inflation, and that all CPI indices exhibiting little moderation in inflation, the supply side of food management would assume critical significance for the government, said the central bank annual report.
The first quarter review of monetary policy conducted in July 2009 had revised the inflation projection to 5% for the end of the year from 4% projected in April 2009, recognising the imminent signs of inflationary pressures, while highlighting the medium-term objective of 3% inflation.
Taking into account global developments, developments in domestic aggregate demand and the recent output outlook for the three broad constituent components of GDP (i.e., agriculture, industry and services), the first quarterly review of the RBIs monetary policy for 2009-10 placed GDP growth for 2009-10 at 6% with an upward bias."
However, since the presentation of the policy statement, while the extent of rainfall deficiency associated with the south-west monsoon has increased, the IIP figures for June 2009 released in August 2009 showed significant recovery in industrial output.
The report has emphasised that the exit options for fiscal policy have to be seen in the context of the fact that economic recovery in itself could allow the automatic stabilisers to operate by raising the revenues and creating scope for reduction in public expenditure.
However, the single mandate linked to inflation objective has often been highlighted as a necessity for ensuring a better inflation environment, but given the importance of other objectives for a country of India's size and diverse needs, the operational relevance of an inflation-centric mandate has to be examined carefully, argued RBI.
A major near-term challenge for the central bank is to deal with the unpleasant combination of subdued growth with emerging risk of high inflation, which poses a complex dilemma on the appropriate stance of monetary policy. In such conditions, while withdrawal of monetary accommodation entails the risk of weakening recovery impulses, sustained accommodation and the associated protracted phase of high money growth can only increase inflation in future.
What would be more important, however, is the discretionary unwinding measures to ensure reverting to the fiscal consolidation path as an essential requirement for returning to the high growth path," said the report.
The large borrowing programmes and high fiscal deficits complicate the challenge even further by accentuating inflationary expectations, which could worsen the actual inflation situation over time while also putting upward pressure on interest rates.
The report has suggested that for any early signs of recovery to gain momentum, private-sector credit must grow. Better monetary policy transmission that could enhance the demand for credit is a key challenge, notwithstanding the usual dynamics of any credit market which may not respond to monetary policy actions.
With the return of capital inflows to the pre-crisis period and revival in demand for credit from the private sector, the costs of any delay in withdrawal of monetary accommodation and fiscal consolidation could increase.
The unemployment effects of a long phase of economic slowdown, with weakly developed social security system, suggest that the government's preparedness for dealing with situations as in 2008-09 should be strengthened. This must include counter-cyclical fiscal stance allowing build up of significant cushion during periods of high growth, said RBI.
But despite the FRBM, fiscal consolidation process remained slow. More importantly, the public expenditure was also not reoriented to address constraints to high growth, such as physical and social infrastructure, observes RBI.
Overall, Indian growth continues to be driven by domestic demand and domestic saving, with foreign capital supplementing within the prudent approach to sustainable current account deficit. Thus, return to 9% growth trajectory would largely be determined by the country's structural fundamentals and the responsive macro-policy environment, explained the report.