Strong growth conditions provide policy space to remain focused on inflation

Gaura Sengupta - IDFC First Bank

The global environment has clearly changed with DM (developed market) central banks initiating rate cuts or providing forward guidance for a rate cut as growth begins to slow.

Labour market conditions in the US are showing signs of weakness with a rise in unemployment rate and moderation in wage growth. Conditions have now reached a state where the Fed has indicated that it doesn’t want to see further weakness in the labour market.

Inflation pressures in the US have eased in Q2 of 2024, with broad-based moderation seen in core PCE (personal consumption expenditure) inflation. The balance of risks facing the Fed have now quickly shifted from ‘upside risk to inflation’ to ‘downside risk to growth’.

Other DM central banks had already begun to deviate from the Fed by initiating rate cuts as growth conditions were already relatively weaker than in the US. The luxury to wait till inflation reaches target levels and then ease policy is diminishing in DMs as growth weakens.

The key difference between the June and the August policies is the change in global setting, which is clearly changing towards lower rates.

RBI's assessment

In India, the RBI’s assessment on growth remains positive and the FY25 GDP growth estimate is likely to be retained at 7.2 percent. That said, there are some nascent signs of moderation in the profit growth, with the growth rate of some non-financial companies declining in Q1FY25, with the rise in input cost pressures.

Urban consumption, which was a key support in FY24, has begun to slow in FY25 as wage growth has moderated. This is reflected in the slowdown in passenger vehicle sales and FMCG urban sales volume growth. On the positive front, rural demand is showing signs of revival in FY25, after being weak in FY24.

A better distribution of the monsoon this year is expected to support rural demand. An improvement in rural labour market conditions is visible, with a decline in demand for jobs under NREGA (National Rural Employment Guarantee Act), since the end of 2023.

The capex cycle, which was the key driver of growth in FY24, remains supported by the government. The full Union Budget maintained allocation of capital expenditure at 3.4 percent of GDP in FY25. The budget is non-inflationary, with enhanced focus on fiscal consolidation. The target for fiscal deficit was reduced further to 4.9 percent of GDP from 5.1 percent in the interim budget.

Food inflation key risk

Strong growth conditions provide policy space to remain focused on inflation. The key risk remains food inflation, which rose to 9.4 percent in June 2024 due to the supply disruption caused by adverse weather events.

Daily food prices indicate that food prices remain elevated in July. However, a significant base effect will pull down overall inflation (on a year-on-year basis). Q2FY25 CPI inflation is tracking at 4 percent v/s RBI’s estimate of 3.8 percent, due to elevated food prices. The spatial distribution of monsoon is uneven, with 41 percent of the country receiving excess rainfall. The impact on food prices will need to be monitored closely.

Against this backdrop, the RBI is expected to maintain status quo on policy rates and the stance in the August policy. The overall tone of the policy will remain cautious, given the elevated food inflation pressures. Core inflation remains the silver lining, remaining at historical lows. That said, PMI (purchasing manager's index) surveys indicate that producers are passing-on input cost pressures to consumers as margin pressures rise.

For now, we maintain FY25 inflation forecast at 4.5 percent, assuming food inflation moderates as supplies improve. The risk to our estimate is tilted to the upside.

The stance of withdrawal of accommodation is likely to be retained, given the risks to inflation outlook. The stance will only be changed when there is confidence that inflation is on a sustainable path towards the 4 percent target. This confidence will only be gained after the monsoon season is over.

Looking beyond the August RBI policy, we see space to ease rates only in October / December 2024. However, this will require moderation in food inflation pressures and no further supply shocks. Regarding the change in stance (to neutral), the earliest window is likely to be in the October policy. We don’t rule out a change in stance and rate cut in the same policy.

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