Today, the Reserve Bank of India (RBI) will once again take stock of the global and domestic economic scenario and brief the markets about its views and course of action. To understand what to expect from the RBI, it would be useful to chronicle recent developments in the domestic and global front which will impinge upon monetary policy.

Global Developments

The two significant global developments are the ECB’s decision to purchase bonds of struggling countries and the Fed’s decision to launch QE3.

The ECB’s decision on September 6 follows the statement by Mario Draghi, its chairman, in late July, that ECB will do ‘whatever it takes’ to save the Euro Zone. It is a much-needed step to keep the yield of sovereign bonds of troubled countries at manageable levels.

The open-ended ECB support would come with a tough conditionality, making the proposal appear a step in the right direction to address Euro Zone woes. The decision by the German constitutional court to participate in the European Stability Mechanism (ESM) — the euro area’s permanent rescue fund — also bolsters the attempt to save the Euro Zone from disintegration. This has come as a relief to Indian markets.

However, the case of the recently announced QE3 could be a different story. Unlike its previous version, which had a definite time-frame, QE3 is open-ended. Under QE3, Fed will purchase $40 billion worth of mortgage debt per month till the unemployment and growth situation improves significantly.

The Fed will strive to bring down unemployment in the US to a more acceptable 5.5-6 per cent from the current range of 8.1-8.3 per cent. The monthly volume of purchase of bonds in QE3 is considerably lower compared to QE2, where monthly purchase amounted to $75 billion.

The problem which started with toxic assets has led to Fed intoxicating the global economy with liquidity. Though the Fed’s measures will provide relief to the markets, to what extent they will be able to deliver remains a question.

Domestic Developments

After a lot of dithering, the Government has made at least some moves to rationalise the prices of petroleum products. On September 13, it decided to increase diesel prices by Rs 5 and cap the supply of subsidised LPG cylinders to six per annum. These measures are expected to reduce the under-recovery of OMCs by about Rs 20,300 crore. Notwithstanding this reduction, the under-recovery for 2012-13 will be about Rs 1,67,000 crore, which is more than the under-recovery of Rs 1,38,541 crore incurred by OMCs during 2011-12.

The increase in diesel prices will run into stiff opposition from parties within the coalition and outside. It would again be a test of nerves for the government.

The decision on the pricing and availability of petroleum products, if not rolled back, will provide some fiscal space, but not enough. From a larger perspective, the increase in the diesel prices is a small step in the right direction.

Will the small, but corrective, step from the Government prompt the RBI to opt for a rate easing? Both deposit and credit growth on a Y-o-Y basis has been relatively less up to August 24, 2012. However, on a sequential basis, only credit growth has been languishing up to this time of the year; deposit mobilisation has fared better. With banks’ investment in G-Secs much higher than the prescribed norm, the demand for a reduction in CRR to infuse liquidity appears hollow.

The argument for a reduction in CRR is premised on the belief that higher liquidity with the banks will enable them to price credit cheaply. It is quite possible that the additional liquidity will find its way to investment in G-Secs rather than credit.

This is more likely when banks are facing problems on the asset quality front, owing to the dampening of growth. Regarding the bankers’ demand for a CRR cut, the RBI is partly responsible for shaping such expectations because it has wavered in the recent past in its communication on the role of CRR in policy-making. For sometime, the RBI linked liquidity with inflation; however, subsequently, it changed its stance. There should not be any doubt that liquidity has an inflationary connotation.

Growth and Inflation

The RBI has traditionally said that it looks into the movement of growth and inflation to shape its policy stance.

Growth has taken a beating. Headline inflation has seen a significant uptick in August, at 7.5 per cent, compared with 6.9 per cent for the previous month. Diesel being a universal intermediary, the first-round impact of the price hike is estimated to add 60 basis points to headline inflation. The second-round impact on the headline inflation will be another 40 bps. Easy liquidity from QE3 will put further pressure on commodity prices, including that of oil.

While the monsoon has recovered in the last one month, its spread has been less than satisfactory. There would be some pressure on prices of primary articles. However, in view of the spate of policy initiatives in the last few days, a small reduction cannot be ruled out either.

(The author is Associate Dean, Xavier Institute of Management, Bhubaneswar. The views are personal.)

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