Monetary reflation needed to balance fiscal consolidation

The Finance Minister has committed to reduce the fiscal deficit to 4.5 percent

By Ankita Pathak

The renewed strength of the dollar has rattled currencies, and resulted in the rupee hitting a lifetime low against the US dollar.

The US Dollar Index (DXY), which measures the value of the USD against a basket of six major currencies, is elevated. Optimism around the economy, possibility of lower taxes, probable efforts to repeal certain Dodd-Frank regulations, and deregulation under Trump’s second term have been contributing to the dollar’s rise.

DXY levels have aggressively moved ahead from 100-levels, prior to Trump’s election, to almost 110 levels today. And shows no signs of abating as long-dollar positions keep rising in the forward market.

The gap between US and Euro yields continues to widen. Long-term U.S. yields remain stubbornly high, with the 10-year treasury yield coming close to the psychological barrier of 5 percent recently. High yields favour the dollar and further exacerbates the money flow into the U.S.

The second half of 2024 witnessed consecutive rate cuts by the U.S. Federal Reserve, totalling 100 basis points, and the easing cycle was expected to extend into 2025 and 2026. While the probability of rate cuts has not receded, the trajectory could proceed in a more subdued fashion and expectations of another 50 bps in 2025 remain ripe.

The growth in payrolls, the dip in the unemployment rate, strong numbers on various data points by the Institute for Supply Management (ISM) data, has given a positive spin to the economy and labour market.

In December, the Services PMI registered 54.1 percent, higher than November's figure of 52.1 percent. The Supplier Deliveries Index registered 52.5 percent, higher than the 49.5 percent recorded in November. The Prices Index registered 64.4 percent in December, from November's reading of 58.2 percent (the first time the index has registered over 60 per cent since January 2024, and the highest reading since February 2023).

Higher inflation anticipation and expectations of a rising national debt are both linked to the uncertainties related to the impact of Trump administration policies. Should Trump institute a wave of large tariffs, the import taxes could send inflation climbing. Resurgence of inflation would slow the pace of Federal Reserve rate cuts.

The Federal Reserve's hawkish pause, a stronger dollar, and higher U.S. bond yields signal caution for emerging markets.

December 2024 saw rate cuts across developed markets; Swiss National Bank, Bank of Canada, Federal Reserve, European Central Bank and Sweden’s Riksbank trimmed benchmark rates. However Emerging Markets have held back. Way back in May 2022, when the Federal Reserve raised rates, the RBI, in an off-cycle meet unanimously and instantly voted to hike rates. Following the path of the Federal Reserve at this time is not a given.

The India dynamic: Weaker currency, sticky inflation, lower growth

The exodus of foreign investor outflows from Indian equities is a combination of rich valuations and rising USD strength, which makes dollar-denominated investments more attractive. Indian equity is yielding close to the U.S. risk-free yield of 5 percent. Consequently, as capital exits Indian markets, the rupee faces added depreciation pressure.

A strong dollar makes Indian imports more expensive and increases the cost of servicing dollar-denominated debt.

The first advance estimate of India’s Gross Domestic Product (GDP) in 2024-25, released by the National Statistics Office (NSO), shows a decline in the real GDP growth rate. Q3FY25 GDP growth forecast was reduced to 6.8 percent from 7.4 percent, Q4 growth target was lowered to 7.2 percent from 7.4 percent, and Q1FY26 was also revised to 6.9 percent from 7.3 percent.

The nominal GDP growth rate, which is the sum of the real GDP growth rate and the overall inflation rate, is estimated at 9.7 percent (lower than the 10.5 percent growth rate projected in the last Union Budget) for FY25.

Worth noting is that India has crossed this terrain in the past.

Post the Global Financial Crisis (GFC) of 2008, the country did exceptionally well.

Then in 2012-13, the stagnation of the global economy delivered a blow to Indian exports, while the high import bill was fuelled by elevated crude oil prices. The ‘taper tantrum’ resulted in foreign institutional investors pulled out money from both equities and bonds, causing the rupee to slide. The policy makers in India grappled with growth slowdown, high inflation and a weakening currency.

Post the Covid pandemic of 2020, India once again did well, and is now facing a moderation in growth.

Looking ahead.

The future trajectory of the rupee depends on the RBI’s intervention strategy amid foreign outflows and a strengthening USD. So far, the RBI has exercised restraint as far as supporting the rupee goes. India’s inflation rate, relative to the global economy, is also a crucial factor. Persistent inflation could weaken the rupee further, making imports costlier and creating upward pressure on India’s current account deficit.

The Finance Minister has committed to reduce the fiscal deficit to 4.5 percent. From the perspective of policy continuity and policy credibility, the probability of fiscal expansion is virtually negligible. The economy will benefit from liquidity support by way of monetary expansion, considering that India’s money supply which grew at 17 percent a few years ago, is now at around 10 percent. Monetary reflation could manifest via a combination of rate cuts and/or liquidity injection.

The December 2024 meeting of RBI's Monetary Policy Committee decided to keep the repo rate unchanged at 6.5 percent for the eleventh consecutive period and maintain a continuation of its neutral monetary policy stance.

While Indian macros warrant a rate cut, global macros make it a harder decision.

All eyes will be on the new Reserve Bank of India governor, Sanjay Malhotra, and the first MPC meeting under his watch in February. Later this month, the U.S. Federal Reserve will hold its meeting. In February, the Union Budget will be unveiled and Trump policy formation shall commence.

Monetary reflation will be important to support the economy amidst the fiscal consolidation.

(Ankita Pathak is Chief Macro and Global Strategist at Ionic Wealth by Angel One)

Views are personal and do not represent the stand of this publication.