How RBI is able to maintain the status quo on rates, stance

Gaura Sengupta - IDFC First Bank

The Reserve Bank of India (RBI) maintained the status quo on policy rates and stance, in line with expectations. The combination of strong domestic growth and external metrics allow the RBI to remain focussed on ensuring that inflation eases to the 4 percent target on a durable basis.

The retention of the ‘withdrawal of accommodation’ stance indicates that the RBI is not in a hurry to cut interest rates as inflation remains above target levels. Two external members (Dr Ashima Goyal and Prof Jayanth Varma) voted for a 25 basis point (bps) cut and change in stance to `neutral', compared to one external member (Prof Varma) at the April policy meeting.

The RBI has the twin protection of strong domestic growth and favourable external metrics (low current account deficit and adequate forex reserves). In FY25, RBI expects GDP growth to remain resilient at 7.2 percent, driven by investment and consumption. Strong growth conditions provide the policy space to remain on pause till there is further clarity on inflation risks.

RBI’s inflation outlook remains favourable, with headline inflation expected to ease to 4.5 percent in FY25 from 5.4 percent in FY24. The heatwave conditions have added to near-term food inflation risks, with upward pressure on perishable items such as vegetables and fruits. Over the next few months food inflation pressures are expected to ease as the monsoon season progresses. Another silver lining is that core inflation has eased to a historical low of 3.2 percent in April 2024, with broad-based moderation across goods and services. Low core inflation indicates that there is slack in the economy, reducing the risk of overheating.

Another indicator that suggests minimal risk of overheating is the low current account deficit. In FY24, the current account deficit (CAD) has likely narrowed to 0.7 percent of GDP versus 2 percent in FY23. The current account is the gap between savings and investments in the economy. The reduction in the gap indicates lower reliance on external savings to fund domestic investments. This provides protection from volatile global conditions. In FY25, the current account deficit is expected to remain low, at 1.3 percent of GDP (a CAD of below 2 percent is considered moderate), and crude oil prices are also expected to remain moderate.

Yet another factor which shields against volatile global conditions is adequate forex reserves. India has more than 11 months of forex reserves (spot reserves plus forward book), i.e., the current level of reserves can cover 11 months of imports. This is more than adequate and significantly higher than the taper tantrum period of 2013, when the Indian rupee saw a sharp depreciation. Import cover then was as low as 6.6 months.

The earliest the RBI can cut interest rates is in October 2024. By then, the monsoons will be over and there will be greater clarity on food inflation risks. There will also be more clarity on the Fed policy. RBI is expected to lag the Fed in terms of the quantum and timing of rate cuts, as interest rate differentials between India and US have reduced to a historical low.

Meanwhile, developed market (DM) central banks are beginning to deviate from the Fed by initiating rate cuts. The luxury of waiting for the inflation to reach target levels and then ease policy is diminishing in DMs as growth weakens even as inflation pressures ease. The Fed, in contrast, has the buffer of strong growth, allowing it to remain on pause till inflation shows sustained moderation towards the target level.