Rates to continue to rise in India

That is my read of the RBI's annual policy statement for FY08. The following is the gist:

Overall Assessment

· While there is evidence of structural changes underlying the recent Indian growth experience, there are also indications that the upsurge of demand pressures may contain a cyclical component. The structural changes include a step up in the investment rate supported by a sizeable increase in the rate of gross domestic saving, the growing linkages of the Indian economy with the global economy and the indications of improvements in productivity in industry and services.

· Among the cyclical factors, first, robust global GDP growth has been supportive of high growth in India. Second, the persistence of high growth in bank credit and money supply, the pick-up in non-oil import growth and the widening of the trade deficit together indicate pressures on aggregate demand. Third, cyclical forces are also evident in the steady increase in prices of manufactures, resurgence of pricing power among corporates, indications of wage pressures in some sectors, strained capacity utilisation and elevated asset prices.

· A significant worrisome feature of domestic developments in 2006-07 is the firming up of inflation, which represents the key downside risk to the evolving macroeconomic outlook. The recent hardening of international crude prices has heightened the uncertainty surrounding the inflation outlook.

· A careful assessment of the manner in which inflation is evolving in India reveals that primary food articles have contributed significantly to inflation during 2006-07. At the same time, prices of manufactured products account for well above 50 per cent of headline inflation.

· Indian financial markets have experienced some volatility in the fourth quarter of 2006-07 alongside sizeable swings in liquidity and a hardening of interest rates across the spectrum. During episodes of tightness, contrasting conditions were often observed when short-term interest rates had firmed up but long-term rates had declined in the Government securities market.

· While capital flows to emerging market economies and, in particular, to Asia in 2006 have reflected the improvement in macroeconomic performance, they were also driven by a search for yields and a stronger appetite for risk. Consequently, reversals of capital flows can pose challenges to emerging economies, particularly in the context of withdrawal of monetary accommodation in developed economies.

· In the event of demand pressures building up, increases in interest rates may be advocated to preserve and sustain growth in a non-inflationary manner. Such monetary policy responses, however, increase the possibility of further capital inflows, apart from the associated costs for growth and potential risks to financial stability. Thus, foreign exchange inflows can potentially reduce the efficacy of monetary policy tightening by expanding liquidity.