Inflation in India is artificially suppressed: RBI

Rise in retail prices of fuels could raise inflation from below 4%.

In an indication that it may hold back a policy rate cut tomorrow, the Reserve Bank of India (RBI) on Monday said inflation in India was artificially “suppressed” as higher international oil prices have not been passed on to domestic consumers.

In its report on macro-economic and monetary developments a day before the third quarterly review of its 2007-08 monetary policy, RBI also said “elevated international food prices also pose potential inflationary pressures in the period ahead.”

Notwithstanding the underlying inflationary pressures, central banks in the US and other advanced economies have resorted to monetary easing in order to forestall the adverse impact of the tightening credit conditions on their broader economies.

In the US, headline inflation firmed up to 4.1 per cent in December 2007 from 2.5 per cent a year earlier mainly due to higher food and energy prices.

In India, inflation based on the wholesale price index (WPI) has remained below 4 per cent since mid-August 2007, partly reflecting moderation in the prices of primary food articles and some manufactured products items as well as base effects.

RBI’s target is to contain inflation close to 5 per cent in 2007-08, but increase in retail prices of major transport fuels could lead to price levels breaching the comfort levels.

Bank credit growth has moderated to 22 per cent from 28 per cent in 2006-07 and 32 per cent in 2005-06, consistent with policy projections, but elevated money supply (M3) continues to pose risks of higher inflationary expectations.

M3 is currently ruling at 22.4 per cent against the indicative target of 17-17.5 per cent for 2007-08. RBI has listed issues and concerns arising from the global financial market developments caused by large losses from US sub-prime mortgages.

It said the practices of increased use of innovative credit instruments and complex layering of risk diffusion have taken the investor or risk taker to become progressively remote from the ultimate borrowers where the actual risks reside.

The second concern is about the role of rating agencies, which has also come under scrutiny. The issues such as small number of rating agencies and the possible conflict of interest clearly suggest that the reliance only on rating agencies for risk assessment needs to be avoided, RBI said.

Third, as far as role of central banks is concerned, on one hand, there is a view that increased credibility of monetary policy has enhanced expectations for stability in both inflation and interest rates, which has led to mispricing of risk and hence enhanced risk taking.

On the other hand, another view is the repeated assurances of stability and guidance to markets about the future path of interest rates by the central banks, coupled with the availability of ample liquidity have led markets to under-price risks.

Fourth, the confidence is also falling in the strength of the insurers that guarantee payments on bonds (monoline industry). Two major bond insurers are reportedly have huge exposures in securities backed by assets, including sub-prime mortgages.


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