With the upward pressure on inflation still continuing, the central bank's first quarter review of the monetary policy emphasizes the need for continued policy action to manage liquidity to hold inflation within 5 per cent.
Finance Minister P Chidambaram on Friday had said that "enormous liquidity" posed inflationary risks and the government would take all steps necessary to curb them.
Reflecting this, the RBI has said, "Assuming that aggregate supply management will continue to receive public policy attention and that a more active management of the capital account will be demonstrated, the outlook for inflation in 2007-08 remains unchanged."
RBI's purchases of dollars to check the rupee's rise have been infusing rupee liquidity into the system, which in turn poses inflationary risks. The priority in policy making would be to contain inflation within 5 per cent in 2007-08, while reinforcing the medium-term objective to reduce inflation to 4-4.5 per cent on a sustained basis.
At the current juncture, a higher priority needs to be accorded to managing appropriate liquidity conditions in the policy hierarchy given the recent developments in the financial markets in India and the potential uncertainties in global markets, said the RBI.
Net capital flows were buoyant in 2006-07, nearly doubling to $ 44.9 billion from $ 23.4 billion in 2005-06.
"The disaggregated composition of capital flows will have to be taken into account in looking at the financial balance. How much of physical asset creation has resulted from FDI flows and also FII flows whether it is through own accounts or other accounts. The issue of participatory notes is there," said Y V Reddy, governor, RBI.
Portfolio flows picked up on account of foreign institutional investors, amounting to $8.4 billion during 2007-08 (up to July 13) compared with an outflow of $2 billion a year earlier.
Foreign direct investment inflows during April 2007 were at $1.6 billion up from $0.7 billion a year ago.
The surge in capital flows and large changes in liquidity conditions had made an accurate assessment of risks difficult.
The RBI has noted that while inflation has come down in the recent period, upward pressures persist. "While noting the inflation environment in recent weeks, it is necessary to continuously assess the risks to the inflation outlook emanating from high and volatile international crude prices, the continuing firmness in key food prices and the uncertainties surrounding the evolution of demand-supply gaps globally as well as in India," said the RBI.
International crude prices have risen beyond the $ 70 level and are extremely volatile, representing a serious risk to inflation expectations. Even the projected $65.7 per barrel in 2007, prices would remain considerably higher than the level of $ 53 per barrel at the beginning of the year.
"It is difficult to differentiate, ex ante, the permanent and temporary components of the elevated international crude prices but, in any case, they would have implications for domestic inflation conditions," said the RBI.
Domestic prices of petrol and diesel have undergone two downward revisions during 2006-07 and at their current levels, the need for some more pass-through from recent movements in international crude prices has to be recognised, according to the central bank.
"The demand pressures and cyclical effects also persist, mirrored in investment and consumer demand, monetary and banking aggregates, capacity constraints and a widening trade deficit," said the RBI.
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