RBI likely to opt for a prolonged pause until middle of next year

The focus of the monetary policy has remained on keeping the liquidity conditions tight, after a pause in April 2023. The need to keep liquidity conditions tight is driven by the upside risk to inflation from successive food price shocks. Adverse weather events have resulted in more than 50 percent of the CPI food basket (by weight) seeing 6 percent+ inflation. The share is likely to rise to more than 60 percent in November due to rise in vegetable prices led by onions.

The RBI has rightly decided to look through the food price shocks as core inflation remains well behaved and inflation expectation contained. However, recurrent food price shocks raises the risk of generalisation of price pressures (spreading from food to non-food). To prevent this RBI has kept liquidity conditions tight via Incremental cash reserve ratio (I-CRR) over August to October first week. As a result, weighted average call rates have remained closer to marginal standing facility (MSF) rate.

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In the October policy, the RBI had surprised the market by indicating the possibility of open market operations (OMO) sales (through auction) as a tool to tighten liquidity. Since then, liquidity conditions have tightened, without the need for OMO sales. This was led by rise in currency leakage in November with the onset of the festival season and the RBI’s forex (FX) intervention. The window for OMO sales (through auction) remains limited in the near-term with liquidity conditions expected to tighten.

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Currency leakage tends to rise in the second half of the financial year, seasonally. Further drain on liquidity has risen from the RBI’s FX operations as balance of payments has turned negative since Q2FY24 from a substantial surplus in Q1. In Q3FY24, balance of payments has remained mildly negative with trade deficit remaining elevated and sharp slowdown in FDI inflows.

FPI inflows in debt have turned mildly positive in November, ahead of India’s inclusion into JPM EM bond indices. However, a significant pick-up in inflows into G-secs is expected to take place closer to start of index inclusion next year. Hence, for now, we don’t see the space for OMO sales (via auctions) with core liquidity expected to reduce to Rs 1.8 trillion by December-end 2023 from Rs 3 trillion as of October-end 2023.

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The policy space to focus on inflation, is provided by growth conditions remaining strong. Growth in H1FY24 was stronger than expected at 7.7 percent, supported by urban demand and government capex. Few transient factors have also aided growth with reduction in input cost pressures which supported listed company profits.

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In H2FY24, some moderation in growth conditions is expected as government capex (Centre and states) has likely been frontloaded ahead of the elections. Moreover, support from reducing input costs, is expected to reduce in H2 with WPI inflation turning mildly positive. The strong H1FY24 GDP growth is likely to result in RBI revising-up its FY24 GDP growth estimate to 6.8 percent from 6.5 percent.

Against this backdrop, policy focus will remain on ensuring disinflation process and aligning inflation with 4 percent target. Headline CPI inflation is expected to be around 6 percent in November and December, due to food inflation pressures and adverse base-effects.

After that inflation is expected to stay above 5 percent till Q1FY25, which is higher than the RBI’s 4 percent inflation target. Hence, the RBI is likely to remain on a prolonged pause into middle of next year. In the interim, focus shall remain on keeping liquidity conditions tight which will aid transmission of past rate hikes and prevent development of second round-effects.

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