Inflation Vs Resilient Economy: What Is Stopping RBI From Cutting Rates In Upcoming Monetary Policy?

The market is torn into opinions as to what RBI may decide on Friday, April 5th when it will announce the first bi-monthly monetary policy of FY25. The consensus is that RBI may hold rates for the seventh time in a row, but the April 2024 policy is also at a time when everyone is hoping for some clarity on rate cuts and policy easing while gauging the transmission of aggressive rate hikes that were the aftermath of Russia's invasion of Ukraine globally.

Right after the Kremlin's all-out invasion of Ukraine in late February 2022, inflation spiked to a multi-decade high in Western and emerging economies. India too faced the brunt of multi-year high inflation which led RBI to a series of aggressive hikes in the policy repo rate, pushing the key rate to 6.5% highest since August 2018.

But rate hikes come with a price-to-pay in its pattern, and not only RBI but other global central banks could not afford that. However, FY24 was much more comforting than FY23 with resilient economic growth and cooling off inflation at a slower pace which led RBI to keep rates unchanged at 6.5% since April 2023. FY24 did not see any hike and neither cuts in repo rate hence.

The start of FY25 is expected to be on similar lines with RBI keeping rates steady and retaining its 'withdrawal of accommodation' stance in the April 2024 policy. But the bigger question remains, when exactly does RBI plan to cut rates and ease its policy stance, as it will be a big boost to the financial market including the rupee. This is why the April policy will be gauged for such clarifications.

A dovish remark by RBI on April 5th will be a sweet symphony for the street as it would fuel hopes of rate cuts in early policies.

The current scenario is strong economic growth vs inflation risks due to rising food prices, and an easing liquidity system.

Giving a brief view of what has happened among other central banks before RBI's policy, Sujan Hajra, Chief Economist & Executive Director, Anand Rathi Shares and Stock Brokers pointed out the Federal Reserve has made dovish commentary. Hajra further explained that rate-cut expectations in the US have been significantly re-priced, with the consensus moving from six cuts to three in CY24. The sticky inflation in the initial months and the strong growth led the Fed to raise its expectations of growth and inflation.

Further, the economist also highlighted BIS estimates the natural rate of interest being higher, post-pandemic, which implies that the policy is not as restrictive as previously thought (affirmed by financial conditions indices, suggesting easiness). Hence, though little economic logic, the backdrop of presidential elections may make the Fed hesitant to cut rates toward the year-end, with a 50/50 chance of June cuts. Besides, parts of Europe have already or are about to enter an easing cycle. This has pushed DXY higher, which would be a negative for the rupee.

GDP Growth Vs Inflation:

According to Hajra, FY24 GDP is likely above 8%. Q3 saw GDP growing a robust 8.4% on strength in fixed investments and discrepancies, and a downward revision in last year's revised estimates. Further, the CSO projected 7.6% growth for the entire fiscal, implying ~6% growth in Q4. On the other hand, strong growth across high-frequency indicators suggests that growth is likely to be above 8% in Q4.

The chief economist said, "This means current year estimates would be further raised to 8.1%. While this seems like an above-trend growth, it is unlikely to stimulate core inflation as much of this growth is being driven by investments."

Coming to Core inflation bottoming, Hajra added, "Volatility in food stays."

Data since Dec'23 suggest a meaningful easing of inflationary pressure, which fell from 5.7% then to 5.1% in Jan/ Feb'24. The reason for optimism is continuous disinflation in the core CPI, now below the RBI's 4% target. And, yet, we reckon the apex bank is unlikely to take comfort from this as it targets headline and not core CPI.

"Our food price index suggests that after bottoming in Jan'24, food prices are on an accelerating trajectory and, while official figures are not yet out, we see food inflation for Mar'24 being near 8%. DCA data suggest that, while more stable components of food are now declining, volatile components like fruit and vegetable prices are rising," Hajra said.

Hajra further said, "This heightened volatility in food prices over the past few months has created uncertainty about the RBI's outlook, preventing it from entering an easing cycle soon. Finally, there are reasons to believe that core inflation may bottom out in the near term as higher growth prospects for the US and China have pushed commodity prices higher."

Liquidity:

Moreover, liquidity conditions eased. Hajra said, "Per our initial expectations, while the overall deficit holds, year-end government spendings has led to easing of interbank liquidity. This has brought the WALR near the repo rate as against the MSF, where it was at the end/beginning of the last/current year. Ahead, we think the RBI would ensure the system stays in a deficit mode for seamless, complete transmission of rate hikes."

Hence, Hajra expects another status-quo policy. The economist added, "With the latest data on inflation and growth affirming our previous view, we reckon the RBI is unlikely to cut rates in CY24. We see strong growth continuing in FY25 (the RBI's latest bulletin estimates 7.4% growth) and above-target inflation persisting."

Meanwhile, Vaibhav Shah, Fund Manager, Torus Oro PMS said, "We expect the MPC to maintain the status quo on rates with very low expectations on rate cut in H1FY25. Though inflation is showing signs of moderation, food price shocks, geopolitical tensions, supply chain disruptions, upcoming general elections, bond index inclusion flows etc may add to some volatility which may lead to MPC maintaining withdrawal of accommodation stance. The recent quarterly GDP and the expectation of strong GDP numbers going ahead may also lead MPC to hold rates till next few months."

While the majority are expecting the status quo, the possibility of a change in stance is not ruled out.

Parijat Agrawal, Head - Fixed Income, Union Mutual Fund said, "We do not expect any change in the policy rate, but a probable explicit or implicit change in stance cannot be ruled out. RBI may acknowledge that core inflation is trending down. We expect growth projections to continue to remain robust. RBI is expected to touch upon the smoothening of liquidity conditions. Systemic liquidity shall improve going ahead. "

Some expect a change in policy stance in either of the next two policies, with expectations of a repo rate of 6.5% still.

Shraddha Umarji, Economist - Institutional Research at Prabhudas Lilladher said, "Reserve Bank of India will likely keep the repo rate unchanged at 6.5%. Stance will also be unchanged for better transmission of the delivered rate hikes (of 250 bps so far). Right now, food inflation is high so the biggest risk going ahead is monsoon. IMD has forecast a normal monsoon for the year, so timely kharif sowing can bring down food inflation. Till then, RBI is unlikely to cut interest rates."

So when? Umarji added, "The central bank will also take cues from what the Fed and ECB are doing when it comes to rates. So it is unlikely that rate cuts will happen before October. However, RBI could change its stance to 'neutral' in June or August. Meanwhile, GDP growth for FY25 might be revised upwards to 7.3-7.4% from 7% earlier as all macroeconomic data has been robust."

Currently, the policy repo rate under the liquidity adjustment facility (LAF) is unchanged at 6.50%. Consequently, the standing deposit facility (SDF) rate remains unchanged at 6.25% and the marginal standing facility (MSF) rate and the Bank Rate at 6.75%. Also, MPC decided to remain focused on the withdrawal of accommodation to ensure that inflation progressively aligns to the target, while supporting growth.