Inflation forecast to offer critical rate cut guidance, says MPC's Shashanka Bhide

One basis point is one-hundredth of a percentage point.

With Consumer Price Index (CPI) inflation falling sharply to 4.25 percent in May, speculation is rife that the rate-setting panel could start cutting interest rates in the second half of the current financial year. However, the MPC has made it a point to say that the rate hike cycle is not necessarily over, and that it stood ready to take "further monetary actions promptly and appropriately" as needed to keep inflation expectations firmly anchored and bring it down to the 4 percent target.

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Although inflation has fallen significantly in the first few months of 2023, it has been thanks to a favourable base effect. As this wanes, CPI inflation is seen to be rebounding from an average of 4.6 percent in April-June to 5.2 percent in July-September, 5.4 percent in October-December, and 5.2 percent in the final quarter of 2023-24.

According to Bhide, an honorary senior advisor at the New Delhi-based National Council of Applied Economic Research, the forecast of 5.2 percent headline for January-March 2024 "appears likely, for now".

"The forecast comes with errors on both sides. Global demand conditions would play a crucial role in influencing commodity prices, including that of some of our crucial inputs. Agricultural output this year would also be subject to weather uncertainty," he added.

Inflation focus

The MPC's latest decision seemed to suggest a reinvigorated focus on bringing retail inflation down to the medium-term target of 4 percent, with some economists consequently pushing back their rate cut predictions from late 2023 to early 2024. Bhide, however, said that achieving the 4 percent target has always been the medium-term goal — one which was made challenging in recent years due to exceptional disruptions caused by the pandemic and geopolitical conflicts.

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"During the course of the present policy tightening it was noted that the goal would be to bring the inflation rate to within the tolerance band of the target, and then to the target," he said.

A key variable in the MPC's discussions has been the real policy rate, currently estimated at around 1.3 percent, but expected to rise in the coming months as inflation forecasts moderate. Asked if a rising real policy rate put pressure on the MPC to cut the repo rate, Bhide said it was necessary to sustain the moderation in inflation expectations.

"Given that the policy tightening is to moderate the inflation rate, policy rates would have to be calibrated appropriately," he added.

In the minutes of the June 6-8 meeting, Bhide had expressed concern about the inflation trends in March and April, with many sub-categories of the CPI — such as cereals, milk, clothing and footwear, and household goods and services — all posting 6 percent-plus inflation numbers.

Six percent is the upper limit of the RBI's tolerance band for headline retail inflation.

Bhide remains concerned on multiple counts even after the May CPI data.

"The significant sectoral differences in the price rise even when the overall inflation rate has moderated; uncertainty over both the impact of El Nino, and energy prices affected by geopolitical conflict; elevated inflation in the major economies; and the favourable base effect that may decline combined with the (price) momentum that may increase. There was also concern regarding the potential for price rise in sectors with strong demand because of cost pressures," he said.

As such, it would be important to assess the relative inflationary pressures from these factors as against the impact of lower commodity prices and weak external trade demand.

Growth optimism

India's recent macroeconomic environment is being described as a 'Goldilocks' phase; not only has inflation fallen, but growth has been faster than anticipated, with the Indian economy expanding by 6.1 percent in January-March, forcing the statistics ministry to raise its full-year growth estimate by 20 basis points to 7.2 percent.

According to Bhide, the government's flagship Production Linked Incentive scheme has "certainly provided" a push to several sectors.

"The high growth in January-March has also reflected the robust revival of demand for sectors such as travel, transport, and contact-intensive services. We need to see sustained broad-based revival of both domestic consumption and investment spending," he said.

Sectorally, the growth performance has been uneven. The manufacturing sector, for instance, contracted in two of the four quarters of 2022-23, resulting in a full-year growth of just 1.3 percent. According to Bhide, while a number of steps have been taken to revive manufacturing growth and the sector is working at high rates of capacity utilisation, weak global demand conditions have taken a toll on the sector.

"To drive growth we may need to address disruptions caused both by the pandemic, as well as by changes in supply chains and technology," he said.