In a decision contrary to expectations of a majority of analysts, the Monetary Policy Committee (MPC) paused—unanimously—in the review meeting, holding the policy repo rate at 6.5%. At the same time, the stance of policy remained “focused on withdrawal of accommodation”. The RBI Governor emphasised that the pause was only applicable for this review, and the MPC retained the flexibility to respond to evolving economic and financial conditions.
The economic forecasts for FY24 were also slightly shaded compared to the February 2023 review. GDP growth is projected to tick up to 6.5% from the earlier 6.4%, and CPI inflation weaken slightly to 5.2% from the earlier 5.3%, caused only due to a significant fall in the fourth quarter. One of the crucial assumptions underlying this forecast is a revision down of crude prices to $85/barrel, from the earlier $95 in February 2023.
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It can be surmised that MPC members had become cautious in the face of the extreme uncertainty which now characterises the global economy and policy responses, and of the potential spillovers into India. Globally, central banks now face a difficult balancing act. Most G10 central banks have moderated the pace of rate increases to the conventional 25 bps (except the European Central Bank, which started tightening late), and have changed their forward guidance on policy tightening away from automatic increases to becoming more “data dependent”. One benefit of G10 central banks approaching their peak rates is that global financial conditions will further ease, reducing depreciation pressures on the rupee, thereby attenuating the need to embed a currency defence component in the interest rate.
In addition, India’s external conditions have further improved and remain reasonably comfortable. The Governor emphasised that the “significant narrowing of the current account deficit to more sustainable levels” and “comfortable levels of foreign exchange reserves” will bolster India’s macroeconomic stability. India’s services exports remain exceptionally strong and have broadened from IT services to Business Process Management, engineering services and global capabilities centres. Indian banks have stable, largely deposit-based funding, ample liquidity, little or no exposure to startups, and asset books have large high quality liquid assets.
Yet, balancing the rate pause, the communication and forward guidance seem to be, if anything, more hawkish than in the previous reviews. In addition to the stance, the Governor repeatedly emphasised that the repo rate hold only pertains to the current review, and is in no way a “pivot” [to a more neutral or accommodative policy response], the MPC remains watchful, its “job not yet finished”. Given overall macro and financial sector stability, price stability remains a priority and the war against inflation has to continue till “a durable decline is seen in inflation”, given the unyielding core inflation. These strictures are understandable, since a signal, however mild, of a prolonged pause, let alone a potential cut, would have been premature, leading quickly to easing of financial conditions. This has already happened to an extent through a drop in bond yields and a rise in equity indexes, and a further material easing might result in a de facto reversal of policy rate tightening.
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This brings us to an assessment of likely economic conditions over the course of FY24. RBI recently assessed it its bulletin that the economy remains resilient, with “a steady gathering of momentum since the second quarter” of FY23. High frequency economic indicators, while moderate, remain robust. The services sector remains particularly strong in both domestic and export markets, as the March ’23 Purchasing Managers Index attests. Probably as a reflection of this, core inflation remains uncomfortably persistent, with the number of components above 6% still above 57% of the total. As mentioned above, India’s external balance sheet has also improved (and the narrowing current account deficit, particularly net exports, is probably one of the reasons for the slight upgrade in RBI’s growth forecast). Yet, these are largely rear-facing indicators. Anecdotal evidence and conversations with automobile dealers and builders suggest a slowdown in demand in certain segments, particularly affordable housing and lower cost passenger vehicles. Despite moderating input costs, working capital (WC) loan cycles are getting elongated and utilisation of WC limits rising, a sign of delays in receivables.
Yet, there remain upside risks to inflation, with continuing demand resilience, and the prospect of multiple supply shocks. Electricity tariffs are likely to be raised, which will feed into production costs. Wages and salaries in the formal sector are expected to rise in FY24. Emerging weather risks can increase food prices. Crude oil production cuts can feed into energy prices. An improvement in global growth can increase metals and ores prices.
RBI’s management of system liquidity, which is likely to become structurally zero or even deficit sometime in FY24, will help guide short term market interest rates within the 50 bps rate corridor and thereby calibrate transmission of cost of funds for lenders and borrowers. Durable liquidity, which includes the central government’s balances with RBI, is likely to be about Rs 1-1.5 trillion, and withdrawal of cash (currency in circulation) will gradually drain this over FY24. If capital flows begin to come in, this can offset part of this drain, but the system will still be in deficit.
Despite the MPC’s commitment to respond with further rate changes as appropriate, it might not be easy to resume rate hikes after a pause, unless there is a material change in price conditions, say a large shock in crude oil prices. However, as of now, no cut is foreseen in the repo rate in FY24, unless continuing transmission into higher lending rates results in a significant slowdown in aggregate demand and economic activity, with growth slowing much below the current forecast.
The writer is executive vice president & chief economist, Axis Bank Views are personal
