RBI maintains repo rate at 6.5%; Inflation expectations enter ‘single-digit zone’

As was widely anticipated, the Reserve Bank of India in its 3-day Monetary Policy Committee (MPC) meeting chose to take a wait-and-watch approach, maintaining the status quo on policy rates.

In a unanimous decision, the repo rate remained unchanged at 6.5%.

5 of the 6 members voted in favour of maintaining a hawkish policy stance of ‘withdrawal of accommodation.’

Although economic activity continues to be resilient, the RBI identified high inflation as the main threat to macroeconomic stability, having surged amid volatile food prices in July and August.

Despite welcome moderation, the consumer price index (CPI), the official measure of retail inflation remains above the RBI’s tolerance band of 4% (+/-) 2%.

The RBI Governor Shaktikanta Das reiterated that the inflation target was 4% and not 2%-6% while stressing that India’s growth story has remained strong despite global challenges.

The committee came to its decision given that cumulative hikes of 250 bps are yet to be fully transmitted through the economy.

In addition to the repo rate, the Standing Deposit Facility Rate (SDF) remains unchanged at 6.25%, while the Marginal Standing Facility Rate (MSF) and Bank Rate continue to be at 6.75%.

Inflation

Encouragingly, headline inflation has eased from its peak of 7.4% YoY in July to 6.8% in August.

In addition, headline inflation saw a healthy moderation to 4.6% YoY in Q1 (Apr-Jun) as compared to 7.3% YoY during the same interval in the previous year.

However, the overall inflation outlook remains unclear due to uncertainty around the Kharif season sowing and harvest, elevated global oil prices, El Nino-led weather patterns, and the potential for supply shocks to both food and energy.

India, like many other developing nations, has a high weightage (well over 40%) attributed to food items within the official measure of retail inflation, the consumer price index (CPI).

Although efforts to improve irrigation, logistics, warehousing, and the functioning of agricultural markets continue to make progress, farmers and consumers remain susceptible to unforeseen changes in weather patterns.

For instance, vegetables make up approximately 6% of the CPI basket but contributed approximately one-third and one-fourth of headline inflation in July and August, respectively.

Pulses, cereals, and oilseeds continue to see persistent upward price pressures, although the reduction in LPG prices at the consumer level is a welcome development.

Fortunately, food inflation, which stood at 10.4% YoY in August, is expected to continue to moderate in the months ahead.

Core inflation and inflation expectations

In a key development, core inflation has continued to soften to 4.9% YoY in both July and August, easing by 1.4% from its recent January 2023 peak.

In addition, the RBI has been very active in terms of surveys, with Governor Das noting that inflation expectations are showing signs of becoming anchored, having for the first time since the global pandemic,

…entered the single-digit zone.

In September 2023, 3-month ahead inflation expectations fell to 9.1% from 10.0% in July 2023, while one-year ahead expectations fell to 9.9% as against 10.3% in the previous report.

He stressed that the situation,

…call(s) for careful monitoring of incoming data and the outlook to clearly delineate the durable components of price shocks from its transitory elements.

Inflation projections have been maintained at 5.4% for FY24, with Q2, Q3, and Q4 expected to be at 6.4% YoY, 5.6% YoY and 5.2% YoY, respectively.

CPI inflation for Q1FY25 (Apr-Jun) is expected to come in at 5.2% YoY.

Growth prospects

Globally, central banks have maintained a hawkish narrative as fears of resurgent inflation continue to fester.

Even as headline inflation has come down in many major economies, it remains above target in most cases.

In such an environment, the Federal Reserve and other major global central banks shall likely maintain rates higher for longer.

This in turn will likely contribute to a stronger greenback, threatening sharper capital outflows from developing countries and pressuring local currencies.

The prevailing macro-environment coupled with geopolitical fragmentation has also fuelled contraction in global trade, with merchandise volumes declining 3.2% YoY in July 2023 as per CPB Netherlands Bureau for Economic Policy Analysis.

Domestic strength

Despite these global headwinds, the Indian economy has continued to be the fastest-growing major economy.

The industrial, manufacturing, and services sectors have seen robust data releases in recent weeks, while investment activity has picked up and has been ably supported by the expansion in government capex.

At present, the central government is on track to increase capital expenditure by 33% over the previous fiscal.

Domestic demand has continued to be robust on the back of healthier balance sheets across banks and corporates, as well as improvement in the functioning of supply chains, and is expected to see a further uptick heading into the festive season.

This is supported by several data points including a nearly 32% YoY increase in retail borrowing in July 2023; record-high sales of passenger vehicles in August 2023; and a projected 7% increase in domestic air travel during September 2023.

Broad-based credit growth as well as improved asset quality also augurs well for the financial system.

However, it should be noted that The Centre for Monitoring Indian Economy (CMIE) found that consumer sentiments had dipped by 1.5% in August 2023.

As was widely anticipated, the RBI maintained the full-year growth forecast at 6.5% YoY.

Q2, Q3, and Q4 GDP growth are projected at 6.5% YoY, 6.0% YoY, and 5.7% YoY, respectively.

For Q1FY25 (Apr-June), the RBI maintained an unchanged forecast at 6.6% YoY.

Liquidity conditions

To ensure that market liquidity is in sync with the MPC’s decisions, the committee introduced an incremental cash reserve ratio (I-CRR) of 10 % earlier in the year, which ‘impounded’ approximately ₹1.1 lakh crore from the banking system (approximately USD 13.2 bn).

Combined with advance tax outflows, excess liquidity has seen a strong moderation, while the I-CRR is slated to be discontinued tomorrow, i.e., 7^th October.

The release of the I-CRR funds back into the system as well as the government’s supportive fiscal policies shall drive robust economic activity amid the festive months.

The RBI Governor noted in line with evolving liquidity conditions, open market operations may have to be considered in the near future.

Although financial conditions have remained broadly stable, the distribution of liquidity had recently become more skewed, as a subset of banks borrowed from the MSF, an emergency window that is meant to be utilized when inter-bank markets are not functioning smoothly, while another subset of banks parked funds under the SDF, a tool for absorbing liquidity without collateral.

In addition, the statement noted that it would be desirable for banks to lend excess funds in the inter-bank call market rather than parking these in the SDF at lower rates, which would aid in deepening the inter-bank system.

Given the depreciating factors at play for the Indian rupee, the RBI will likely prefer to keep the policy rate elevated for the time being, while liquidity continues to remain on the tighter side.

Jateen Trivedi, vice president of research at LKP Securities noted,

…the rupee is expected to continue trading within a range of Rs 83.05-83.35.

Final words

The RBI kept the policy rate unchanged at 6.5%, while also maintaining its stance towards withdrawing excess liquidity from the system.

Committee members have elected to wait and watch, while the RBI tracks the transmission of the hiking cycle, developments in global food and energy supply chains, and actions of the Federal Reserve and other central banks.

The US Bureau of Labor Statistics (BLS) shall publish nonfarm payrolls (NFP) data and unemployment rates later today, which shall add clarity to the Fed’s near-term inflation projection.

The RBI MPC’s decision was widely expected, while the focus remains on reducing inflation amid volatile food and energy prices.

In terms of growth, Governor Das emphasized that India remained a bright spot in contrast to the slowdown in advanced economies.

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