The Reserve Bank of India monetary policy committee’s (MPC) guidance at the December rate review can be best described as ‘non-committal.’ The Governor, representing the views of the MPC, emphasized the importance of price stability, given its regressive impact on the purchasing power of rural and urban households. The Governor balanced this by acknowledging that policy support might be required on a prolonged growth slowdown. Then, there is a need to account for global uncertainties and the almost definite spillover impact on the rupee as well as the domestic financial markets. Navigating through these known and unknowns, the MPC voted to pause on the benchmark rate, instead oiling the financial system by boosting the supply of liquidity.
Four takeaways
Firstly, the evolving growth-inflation divergence was acknowledged and reflected in the revised official projections. After accounting for the disappointing 2Q FY25 GDP growth, 3Q FY25 and 4Q FY 25 forecasts were marked down by 20-60bp, taking the annual FY25 growth forecast down by 60bp to 6.6 percent. Nonetheless, the MPC’s underlying optimism on the growth trend remains, as the quarterly profile is expected to stay above average 7 percent in the first half of FY26. We are more conservative at 6.3 percent y-o-y for FY25, with the bounce in the 2HFY25 likely less pronounced than the committee expects.
Inflation beat official forecasts for a second consecutive quarter, necessitating 90bps and 30bps upward revision in 3QFY and 4QFY projections, respectively, taking annual inflation up to 4.8 percent vs 4.5 percent earlier. Authorities are counting on winter disinflation in the perishables, especially vegetables and kharif harvest arrivals, just as good soil moisture conditions, along with comfortable reservoir levels, augur well for rabi production.
Weather developments remain a key factor that could influence the timeline for achieving a durable alignment with the 4 percent inflation target. The pace of the disinflation trend might be slow if a late winter onset impacts rabi crop sowing. Between 2022 and 2024, the economy has gone through episodes of heatwaves and excessive rains, which has impacted the farm-to-fork supply chains. This has expanded the scope of inflation’s vulnerability beyond monsoon rainfall and resultant reservoir levels. A simple exercise shows a 0.5 correlation between food inflation and the observed annual mean surface air temperature for India observed by the World Bank.
Secondly, what’s next? The RBI MPC will have two more inflation prints and the FY26 Budget on hand by the February 2025 rate meeting. Headline inflation is expected to normalise on the passage of weather-related impact on the food basket, edging back into the 4-5 percent range. At the same time, the FY26 Budget presentation will point to further fiscal consolidation, converging towards the -4.5 percent deficit target. This should set the stage to kickstart rate cuts in February, but it is not a done deal. Global developments remain a key variable, with the US government set to take office in mid-January 2025. Subsequent policy announcements, including those with protectionist or inflationary implications, could influence the US dollar and interest rates, with potential ripple effects on Asian markets, including the rupee and INR market rates. In light of possible volatility, the RBI MPC will lean towards preserving rate differentials by extending the pause and focusing on managing rupee volatility.
Third, while there was limited room to act on the main benchmark rate, policymakers found a middle ground by extending liquidity support ahead of the upcoming squeeze on account of tax outflows, increased currency in circulation, and volatility in capital flows. The CRR will be lowered by 50bps - in two equal tranches of 25 bps each, with effect from the fortnight beginning December 14, 2024, and December 28, 2024. This will take the rate back to levels before the start of the hiking cycle in April 2022 and stands to infuse INR 1.16trn into the banking system, potentially boosting credit supply. Industry observers opined that the CRR cut could translate to a 2-6bps improvement in domestic banks’ net interest income (assuming all funds are deployed for loans). On a structural note, as government spending (a frictional driver of liquidity) shifts towards a just-in-time disbursements approach over the coming years, the need for liquidity infusion is likely to increase.
Lastly, to attract capital inflows, the interest rate ceilings on FCNR(B) deposits will be raised to provide more competitive levels, depending on the tenor. The impact might not be material because existing limits are underutilised. The financial sector players might have preferred a CRR dispensation on incremental FCNR (B) flows.
Overall, the MPC chose to maintain the current stance, recognising potential global uncertainties in 2025. Domestic guardrails will help shield the economy from the worst of storms.
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