Inflation Drives Exit-from-Stimulus Strategies

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The US FOMC continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period and will maintain the target range for the federal funds rate at 0 to 1/4 percent. However, in light of improved functioning of financial markets, the Fed has been closing the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral. To provide support to mortgage lending and housing markets the Fed has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt; those purchases are likely to be executed by the end of this month.

ECB decided to leave the key interest rates unchanged as Euro zone inflation in February is at 0.9% and monetary analysis confirms the assessment of low inflationary pressures over the medium term, with money and credit growth remaining weak. But ECB announced the gradual phasing-out of our non-standard operational measures which includes return to variable rate tender procedures in the regular three-month longer-term refinancing operations (LTROs), starting with the operation to be allotted on 28 April 2010, further allotment amounts in these operations will be set with the aim of ensuring smooth conditions in money markets and avoiding any significant spreads between bid rates and the prevailing MRO (main refinancing operations) rate.

Policy makers in UK on the other hand had to acknowledge emerging evidence on the upside risks to inflation, though at the moment Bank Rate would be maintained at 0.5% despite the fact that UK inflation has increased to 3.5%, above the government's target. BoE would also maintain the stock of asset purchases financed by the issuance of central bank reserves at £200 billion as lending growth to households and businesses had remained weak, reflecting both demand and supply factors and was likely to remain constrained until the banking sector had completed the process of balance sheet restructuring and the refinancing of its own funding maturing over the coming years.

RBI of course decided to act prior to its annual policy review and has increased its key rates by 25 bps citing that containing overall inflation and anchoring inflation expectations have become imperative as inflationary pressures have intensified beyond RBI’s baseline projection and heighten the risks of supply-side pressures translating into a generalised inflationary process. After revision, the reverse repo rate — the rate of interest that the RBI offers banks when they leave their funds with the central bank — is 3.50%, nearly 42% lower than the pre-crisis level of 6%. The repo rate, at which banks can borrow from the central bank, is now 5%, 44% lower than the pre-crisis peak of 9% leaving enough scope for further hawkish measures probably again before its annual review, as headline WPI inflation which on a year-on-year basis stands at 9.9 per cent in February is expected to reach double digits in March 2010.

Focal Points of Indian Union Budget 2010-11

India's recent GDP numbers show that the economy grew 6 percent in the December quarter, as farm output fell 2.8 percent after a drought. The core sector, comprising six key infrastructure industries, grew 9.4 per cent in January 2010, compared with 2.2 per cent in January 2009 and pushes up hopes of a robust rcovery. The prime concern remains inflationary pressures which have built up by 8.9% (WPI based) in this fiscal so far, as compared to 1.51% in the last fiscal, pushed by food price inflation which has built up by a massive 14.7% during thi sfiscal compared to a 5.4% build up in the last fiscal. The Union Budget for the FY2010-11 addressed concerns on fiscal discipline with a plan to reduce the fiscal deficit to 5.5 percent of GDP in the new FY from 6.9 percent this fiscal, and further declines in coming years. Additional borrowing of 1.3% was proposed and given that the fiscal stimulus withdrawal was not aggressive so as to not choke wavering recovery, the case for policy tightening by RBI seems to be stronger. The budget lacked any direct measures to curb rising food prices, further the duty rollback on petroleum could contribute somewhat to inflationary pressures, however, reigning in of the fiscal deficit despite difficult circumstances should help cool long term inflation expectations.

Infrastructure, agriculture and social sector have been the key focus areas of budget 2010-11. From the infrastructure sector perspective, the positives are increased allocation for infrastructure by providing 46% of the total plan allocations, especially with respect to roads and the power sector and clean energy initiatives. The proposed tax relief for investment in long-term infrastructure bonds will further boost investment in infrastructure, while increased refinancing through IIFCL would help bank lending to infrastructure. Bank recapitalisation plans and the farm loan waiver are expected to benefit the banking sector. Much needed measures to boost farm spending and research and lift agriculture sector growth to 4 percent in the medium term were taken. With the key focus on inclusive growth social sector by allocation is around 37% of the total plan outlay, while urban development allocation has been increased by more than 75%.The budget has extended the interest subvention on pre-shipment credit for key export-oriented sectors and similarly extended the housing-loan interest subsidy scheme for another year, thus indicating that the fiscal stimulus would continue to sensitive sectors affected by the global slowdown. The expansion of direct personal tax slabs would help stabilise the nascent demand recovery.

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