"The future policy stance will be influenced by the Reserve Bank's projections of inflation relative to the medium term objective (6 per cent by January 2016), while being contingent on incoming data," RBI said.
RBI also maintained the economy's growth projections for the current fiscal at 5.5%. We take a look at five key takeaways from Rajan's credit policy review and the rationale for his cautious stance.
1) Risks to inflation target: While cheering the recent data on declining inflation, RBI has cautioned that its medium-term target of 6% for January, 2015 still faces upside risks. "Since June, headline inflation has ebbed to levels which are consistent with the desired near-term glide path of disinflation - 8 per cent by January 2015. The most heartening feature has been the steady decline in inflation excluding food and fuel, by a cumulative 111 basis points since January 2014, to a new low," RBI said.
"With international crude prices softening and relative stability in the foreign exchange market, some upside risks to inflation are receding. Yet, there are risks from food price shocks as the full effects of the monsoon's passage unfold, and from geo-political developments that could materialise rapidly," RBI explained.
"For the near-term objective, therefore, the risks around the baseline path of inflation are broadly balanced. However, the undershooting of the objective may be temporary because of base effects. Turning to the medium-term objective (6 per cent by January 2016) the balance of risks is still to the upside, though somewhat lower than in the last policy statement," RBI cautioned.
2) Economic growth prospects: According to RBI the momentum of activity in all sectors of the economy is yet to stabilize. "Agriculture should shed the effects of recent shocks and pick up in Q4 of 2014-15. Industrial activity will await improvement in the business environment and the resumption of consumption and investment demand before gaining sustained speed," RBI felt.
"Post-monsoon revival in construction activity and the likely strengthening of momentum in business and financial services should sustain the recent signs of expansion in the services sector," it added.
RBI said that the key to a turnaround in the growth path of the economy in the second half of the year is a revival in investment activity - in greenfield as well as brownfield stalled projects - supported by fiscal consolidation, stronger export performance and sustained disinflation.
"With expectations of these conditions remaining broadly unchanged, the projection of growth for 2014-15 is retained at 5.5 per cent within a range of 5 to 6 per cent around this central estimate. The quarterly growth path may slow mildly in Q2 and Q3 before recovering in Q4," RBI said.
3) Cautious optimism: RBI is of the opinion that the recent cautious optimism that is building in the economy on the back of improved business sentiment needs to be placed on solid foundations through a step-up in investment. "In this context, the resumption of stalled projects should provide a boost to inventory and capex cycles, while reducing distressed bank loans and revitalising growth," RBI said.
4) Stable CAD: Incoming data suggest that the current account deficit, placed at 1.7 per cent of GDP for Q1 of 2014-15 may remain contained in Q2, said RBI. "The improvement in the trade balance has benefited from the fall in the value of gold imports. Even as the external financing requirement stays moderate, all categories of capital flows remain buoyant. As a result, there has been an accretion to international reserves, even though reserves denominated in US dollars have moderated somewhat in recent weeks, largely because of the strength of the US dollar," RBI added.
5) Global concerns: "Global activity has been recovering slowly from the setback in Q1 of 2014, on the back of strengthening consumer spending and gradually improving labour market conditions in advanced economies like the United States. However, the Euro area, where growth has stalled in the core economies, continues to be weak," RBI said.
"Major emerging market economies continue to struggle with tepid domestic demand and headwinds from structural impediments. With monetary policy in advanced economies remaining highly accommodative, investor risk appetite has increased and spread to various asset classes. With volatility perhaps excessively low, financial markets have risen to new highs, driving surges of capital flows to emerging market economies," RBI reasoned.
"Apart from concerns about a sudden correction in financial markets if investors misread the timing of a reversal of the US monetary policy stance or if geopolitical tensions intensify, some downside risks to growth also persist, such as a possible further slowdown in the Euro area," it said.
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