By Indranil Pan, the Chief Economist at YES Bank
This policy, expectedly, was sans any major surprise elements. Policy rates were kept unchanged, and the stance of the monetary policy remained as “withdrawal of accommodation”. The backdrop to this policy was a slowing inflation, especially as vegetable prices dropped. The Governor also indicated that the silver lining is that core inflation has also been moderating and is down 140 bps from the January 2023 peak.
Further, as per the latest Household inflation expectations survey, the 3 months ahead inflation expectation is down by 90 bps while the 1-year ahead inflation expectations is down by 40 bps. RBI’s assessment on growth is that of resilience with demand remaining strong in the urban sector and recovering in the rural sector. Overall, the growth outlook remained unchanged at 6.5 percent for the year as also for FY25.
However, despite all these positives that have been highlighted for the inflation dynamics, there has been no change in heart from the RBI and its commentary and future guidance remains hawkish. This is because of the significant doses of uncertainties that continue to persist on the inflation side. Areas sown on kharif pulses is weak, kharif onion produce needs to be watched, demand-supply mismatches in spices would likely continue. Importantly, the persistence and the deepening of El Nino conditions are likely to continue and have its impact on global food supplies and prices. FAO All Rice Price Index was at 141.7 in September 2023, 0.5 percent lower on a m-o-m basis over August but is 27.8 percent higher than the index level at the same time last year.
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In the next couple of paras, I try to put RBI’s monetary policy perspectives in context to the global perspective. There has been a dramatic transition in the rate environment world over. During the Alan Greenspan era, at the commencement of 2003, we had a 1 percent Fed Funds rate. Subsequently, the rates were floored in the US at 0 percent during the Ben Bernanke days and following the Great Recession of 2008.
Overall, from that time onwards till around June 2022, US Fed Funds rate was below the CPI inflation rate for most of the times. Against that, from the 1982-2002 period, the Fed Funds rate was above the prevailing rate of inflation almost for all times. To put it more simply, before 2008, US economy had witnessed positive real interest rates for significant periods while in the wake of the GFC (Global Financial Crisis, and till very recently, the experience has been of a negative real interest rate. This is true even in the case of the ECB.
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And now, we are returning to the positive real interest rate zone once again. At its last policy meeting, the economic projection as laid out for the US Fed continue to paint a picture of continued resilience of the US economy. The improved outlook, as per the projections, also necessitated the Fed to maintain a hawkish bias to its policy. 12 members now expect the US Fed to hike interest rates by 25 bps in 2023 while 7 others expect a pause. For 2024, the dot plot now indicates only a 50-bps rate cut rather than the 100-bps rate cut expected in the June projections. Thus, the messaging on “higher for longer” is crystal clear and we see the US Fed retaining rates at restrictive levels for longer than in the previous cycles.
Importantly, world over, the sanctity of the target rate for inflation for monetary policy making is gaining prominence. So is the case for India. With monetary policy communication emerging as an important tool for managing and anchoring inflation expectations, the RBI reiterates its intention to achieve the 4 percent handle on a durable basis. The inflation projections put out by the RBI for the remaining part of the year, does not seem to point towards achieving the 4 percent levels.
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For Q1FY25, the RBI projects for a 5.2 percent Headline CPI inflation. Furthermore, for FY25 as a whole RBI’s CPI projection is at 4.5 percent while at YES Bank, we see the average for FY25 at 4.8 percent. With the 4 percent handle eluding on a durable basis, it remains a very difficult option for the RBI to even change its stance of monetary policy to “neutral”, leave aside reducing the policy rate.
Thus, “higher for longer” remains relevant not only for the world but also for India. 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 has narrowed to only about 250 bps, hardly beating the expected INR depreciation on an annual average basis. This interest gap could remain relevant for investors into the Indian debt market, including for investors through the JPM Bond Index inclusion route.
Bond market participants had not anticipated for any changes on the liquidity strategy of the RBI, especially as it winds down the I-CRR (incremental cash reserve ratio). No further measures were announced in this policy. But the RBI once again points to the fact that excess liquidity can raise inflation and financial stability risks.
With this, the RBI brings back to the table the option of OMO (open market operations) sales to manage liquidity. While such OMOs are unlikely to be calendarized, and would depend on evolving liquidity conditions, it has nevertheless spooked the bond market. 10-year benchmark India G-sec yield has consequently risen by nearly 12 bps to 7.33 percent and could continue to reign firm in the near term.
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