Case for rate cuts strong if inflation keeps declining, says MPC's Ashima Goyal

As per the Indian central bank's latest forecast, headline retail inflation is seen declining to the medium-term target of 4.0 percent in July-September 2024 before climbing up again to end the year (2024) at 4.6 percent. Data released on February 12 showed inflation stood at a three-month low of 5.10 percent in January.

Inflation the defining factor

When asked if the current repo rate of 6.5 percent is at an appropriate level for the medium term considering growth is seen remaining robust, Goyal admitted the equilibrium real policy rate is higher in a boom period.

"But the more critical factor is inflation. If headline inflation falls sustainably, a real policy rate of above 2 percent would be too high," she said.

"In the Indian context, inflation defines potential growth. If inflation persists at acceptable levels, we are below potential growth and have space to grow faster. Because of large underemployment, we need growth to rise. If the combination of supply side action and credible equilibrium real interest rates are able to anchor inflation expectations at the target, the policy rate can fall to allow growth to reach a rising potential," Goyal added.

India has clocked a GDP growth of more than 7 percent for three consecutive years, with the RBI predicting that 2024-25 could see the economy expand by 7 percent. At the same time, inflation has been above the medium-term target of 4 percent for 52 months in a row.

Demand not falling

While headline inflation has been difficult to bring down despite the MPC's 250 basis points worth of rate hikes in 2022-23, core inflation – or inflation excluding food and fuel items – plummeted in 2023 and came in at an over-four-year low of 3.6 percent in January.

Goyal, though, does not think the fall in core inflation – which is considered an underlying indicator of demand – is only due the tightening of financial conditions having the desired effect and demand falling.

"It is a combination of factors – the reversal of pandemic-time jump in costs, other factors that have reduced costs, the success of the monetary policy in preventing overheating of demand, and anchoring inflation expectations," she said.

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Managing inflows

Goyal is also encouraged by the government's use of the current growth phase to build up its buffers by improving the fiscal parameters and "making space for future shocks".

"This will also reduce borrowing costs for both the government and the private sector. Already the 10-year G-sec (government security) rate has softened."

Yield on the benchmark 10-year bond settled at 7.07 percent in the secondary market on February 28, having declined by 7 basis points since the end of February after Finance Minister Nirmala Sitharaman surprised markets by setting the fiscal deficit target for 2024-25 at 5.1 percent of GDP and pegging the gross market borrowing figure for next year well below expectations.

Government bond yields are expected to drift further lower in the coming months thanks to demand for them outstripping supply, aided by their inclusion in JPMorgan's global indices starting June.

According to Goyal, managing these foreign inflows into Indian sovereign debt should not be an issue for the RBI and domestic liquidity conditions at a time when the systemic liquidity has become tight.

"Debt flows will come in a staggered manner, and remain low as a percentage of GDP and share of the domestic market – only 1.6 percent of the G-sec market. There is still a cap in place. As GDP and the size of the domestic market rises, we can absorb more without excess volatility. We are seeing this in equity markets. The RBI will be able to sterilise liquidity as required," Goyal reasoned.