RBI may only get a chance to cut rates around the August 2024 policy.
By Indranil Pan, Chief Economist at Yes Bank
India appears to be in a sweet spot – high growth that exceeded everyone’s expectations and containment of inflation dynamics to an extent. The backdrop to this policy was a slowing inflation, especially as the worst of vegetable price increases is beyond us. The markets held on their nerves pre-policy as the RBI had been seen springing some surprises in the past, not from the rates side but in terms of its actions on liquidity.
While, like many central banks across the world had extended their balance sheets to fight the COVID crisis, return to a normal period led to most to soak out the excess liquidity. So did the RBI and while its traditional tools were failing to do the trick, the RBI had surprised the market in August with its announcement of I-CRR and further at the October policy, the RBI brandished the OMO as a tool to absorb liquidity. This policy, thankfully, for the market, did not any such surprise.
On the other hand, the markets are reading this policy as being with a bit of dovish tilt. This is first since the RBI has now reduced the risk of any immediate OMO (open market operation) and further, the speech of the Governor highlighted that the RBI would have to be mindful of the “risk of overtightening”. However, in the press conference, the Governor dispelled any thoughts of the RBI moving into a “neutral” policy stance soon.
Also read: Monetary Policy: RBI improves economic projections…how soon will rate cuts follow?
In my opinion, the RBI would want to be driving cautiously and consistently look for speed bumps ahead and to avoid any accidents. The Governor points out, “Policy makers have to be mindful of the risk of being carried away by a few months of good data or by the fact that CPI inflation has come within the target range.” This is probably playing out world over and even as inflation prints in the US have started to soften, the US Fed continues to harp on keeping policy in a restrictive zone.
Importantly, world over, the sanctity of the target rate for inflation for monetary policy making has gained prominence. The RBI lauds itself and its policy making to say that by prioritizing inflation ahead of growth and by hiking policy rates and tightening liquidity, core inflation has trended lower. Thus, monetary policy is doing the job. But the 4 percent target remains elusive. The RBI has not changed its projections for inflation for Q3 and Q4 FY24 and have retained these at 5.6 percent and 5.2 percent respectively.
Also read: RBI MPC Highlights | Pause no signal of neutral stance, inflation top priority: Guv Das
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For Q1 FY25, the inflation projection is currently placed at 5.2 percent (again unchanged from the previous assessment). For Q2, FY25 the RBI projects inflation to be at 4.0 percent but this would be largely due to the base effects from the previous year. Further, for Q3 FY25, inflation once again is seen jumping back to 4.7 percent. So, there appears to be a very limited window of opportunity when policy interest rates can be reduced.
There are multiple issues at hand. First, core inflation is coming down and is firmly in the 4 percent handle. But remember, GDP growth estimates have been pushed higher by the RBI to 7 percent for FY24 from the earlier 6.5 percent. And the momentum seems to remain strong, whereby the RBI projects GDP at an average of 6.5 percent for the first 3 quarters of FY25. The moot question here – following various policies of the government, has the potential growth risen so sharply already. If not, and I doubt it has, are there signs of the economy overheating. And if the potential growth is not at 6.5 percent, then it is very difficult to see inflation dropping down to the target levels on a sustainable basis.
Also read: RBI retains FY24 CPI inflation forecast at 5.4%, sees it at 4% in Q2 FY25
For now, the risks continue to remain loaded towards the supply side dynamics for price determination. There have been major changes globally to the supply chains and continuing geopolitical and geo-economic shifts create uncertainties. Globally, climate change is an issue and supply worries on the food front remains an issue. Ageing population world over is leading to higher dependency ratios and lower savings and investment. This also is creating the worry of a structurally higher inflation globally.
Finally, closer home, climate change issues have created worries about domestic food price inflation. We did come out of a tomato shock around July/August, but right now, potato, onion and tomato prices are again on the higher side. Cereals is giving some headaches and so is pulses. And the RBI themselves point out that going ahead, “inflation outlook would be considerably influenced by uncertain food prices”. RBI is already expecting a higher inflation print for November and December. Further, rabi sowing is still weak and needs to be monitored for emergence of food price pressures in the future months.
On liquidity, the RBI is probably likely to maintain liquidity just adequate – not too much that it fuels inflation, not too little that it jacks up short-end yields and chokes growth. The positive for the market is that the RBI has lowered the probability of an OMO on an immediate basis, but they have not reduced the chances of the same to zero. In the current uncertain scenario, it would be very difficult to estimate liquidity on an ongoing basis and would crucially be determined by the extent of flows from the globe to India.
In the press conference, the Governor pointed out that there is a positive buzz around India and India will also start benefiting from the Bond Index Inclusion starting June 2024. But some flows can front-run this event and the OMO could be a useful tool at that point. The OMO thought could also have emanated from the low interest rate differential between India and the US. Remember that in October 2023, US interest rates were on an upward journey while India yields had not been moving higher by any significant extent. Now US yields have fallen faster than India’s and has opened the gap between the two, hence also reducing the chance of an OMO immediately.
Thus, the “higher for longer” story remains relevant. It could also be difficult for the RBI to cut rates ahead of the US Fed as the interest gap between India and the US remains to anchor the currency. Assessing the growth-inflation dynamics, we think that the RBI may only get a chance to cut rates around the August 2024 policy.
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