RBI likely to delay rate cuts to Q2 of FY2025

To impose another rate hike, inflation would need to persist above 6.0 percent for at least two quarters.

Despite sizzling prices of tomatoes and other food items causing consternation all around, a third consecutive pause from India’s Monetary Policy Committee (MPC) in its August 2023 policy review was a foregone conclusion. The policy posed very few surprises, with a unanimous vote to keep the repo rate unchanged at 6.5 percent. The stance was retained at remaining focused on the withdrawal of accommodation to ensure that inflation progressively aligns with the target, while supporting growth, with a vote of 5:1. While the sanguine growth forecast was expectedly left unchanged, the inflation forecast was pushed up to 5.4 percent, higher than our expectation (+5.3 percent). Further, the temporary imposition of incremental cash reserve ratio (I-CRR) came as a surprise.

As anticipated, the tone of the document was more hawkish than the June 2023 policy statement, given the rising uncertainties being posed by both food and crude oil prices, and a particularly erratic monsoon distribution, even though its eventual volume may well be in the normal range. The MPC highlighted that it will remain resolute in its commitment to aligning inflation to the target as well as anchoring inflation expectations. In line with the last two policies, the Governor once again stressed that bringing the CPI inflation within the tolerance band of 2-6 percent is not enough and the focus remains on aligning inflation to the target of 4.0 percent. In addition, he enunciated the concern that the frequent incidences of recurring food price shocks pose a risk to anchoring inflation expectations, adding to the hawkishness of this policy statement.

Warning On Inflation

The MPC also warned that the headline inflation is likely to spike in the immediate term given supply disruptions emanating from adverse weather conditions. No sooner than the market internalised that just falling below 6 percent was not adequate, the CPI inflation is set to cross this threshold resoundingly in the soon-to-be-released print for July 2023. We suspect that after the short-lived respite, the July and August CPI inflation prints will be in an uncomfortable range of 6.5-7.0 percent.

No surprises then, that the MPC increased its baseline forecast for inflation for Q2 FY2024 by a huge one percentage point to 6.2 percent from 5.2 percent. Subsequently, it sees inflation moderating to 5.7 percent in Q3 FY2024, and then to 5.2 percent each in Q4 FY2024 as well as Q1 FY2025. Based on the latter, we no longer expect rate cuts to commence in June 2024, and have pushed our forecast for the earliest cut to Q2 FY2025. Moreover, we continue to anticipate the rate cut cycle to be fairly shallow, limited to 50-75 bps.

At the same time, the MPC emphasised the need to be vigilant and to be ready to act appropriately to ensure that the effects of shocks do not persist. While it reassured that it looks through idiosyncratic shocks, it warned that if such idiosyncrasies show signs of persistence, then it would have to act. This does leave the door open for an intermittent rate hike, although the bar for that would be quite high. In our view, inflation would need to persist above 6.0 percent for at least two quarters, amid transmission of pressures to core inflation, to set the stage for a rate hike.

Optimistic On Growth

Notwithstanding external challenges and monsoon-related risks, the MPC remained fairly upbeat on the prospects for domestic consumption and investment. We are particularly enthused by the capacity utilisation figure of 76.3 percent for Q4 FY2023, and are cautiously optimistic about a sustainable and broad-based, albeit realistic, capacity expansion cycle setting in. Moreover, both Central and state government capex has moved well above pre-Covid levels in the last two years. While implementation will remain crucial, we do expect the government to continue to prioritise allocations for capex over the medium term, which would support the growth prospects.  

As per our estimates, the measure on I-CRR will impound liquidity of the banking system of around Rs 900-950 billion. As a result, we expect the short-term rates on money market instruments like call money rates, treasury bills and commercial paper to jump by 15-20 bps in the near term. After the policy announcement, the yield of the current benchmark 10-year government security did waver, albeit in a narrow range. A new benchmark security is set to be unveiled on Friday. Amidst limited fiscal concerns and a high likelihood of an extended pause from the MPC, we foresee its yield in a range of 7.1-7.2 percent over the next two months. As a result of the measure to drain the liquidity overhang, the yield curve will likely flatten further in the immediate term.

Aditi Nayar is Chief Economist and Head- Research & Outreach, ICRA. Views are personal, and do not represent the stand of this publication.