Although there is some uncertainty on the trajectory of food prices, the Monetary Policy Committee (MPC) is justified in looking through the recent spike in the cost of vegetables since these are largely supply-side shocks. The comfort from softer core inflation as also the need to assess the impact of the cumulative tightening of 250 basis points have clearly weighed on the decision to leave policy rates untouched at 6.5%. At the same time, there is some bit of stealth hawkishness in the higher inflation forecast of 30 basis points for FY24 to 5.4% and a cash reserve ratio (CRR) hike on incremental deposits.
That the Reserve Bank of India (RBI) would retain its stance at ‘withdrawal of accommodation’, was widely expected. After all, the central bank has asserted it is determined to tame inflation and bring it down to 4%. However, in a sign that it does not want to let its guard down, it has also opted to soak up some of the excess liquidity with a temporary CRR hike on incremental deposits. This would help mop up about Rs 1 trillion from the system and is aimed at absorbing the excess liquidity created by the return of Rs 2,000 notes. The rule will be relaxed by early September ahead of the advance tax outflow and the festive season so that there is no liquidity shortage at the time. As a measure, it is more appropriate than a CRR hike, which can be perceived as too hawkish.
Indeed, the RBI is anxious about the many imponderables—a shortfall in the kharif output on top of elevated prices of cereals, the impact of El Nino, and the climbing prices of crude oil which are nudging $88 per barrel. It has also pointed out that if higher food prices sustain, they pose the risk of inflation expectations becoming entrenched. But rather than alarm the markets, the RBI has opted to alert them. That is probably why there was scarcely any movement in benchmark yields. What one takes away from all this is that rates are going to stay higher for longer, especially since inflation at the start of FY25 is now estimated to be above 5% levels. As such, a cut in policy rates is now highly unlikely even in early 2024 because the RBI believes the economy is growing well and that there is an incipient recovery in rural India.
In line with this belief, the gross domestic product (GDP) growth forecast of 6.5% for FY24 has been left unchanged. However, while the macro-fundamentals may be stable, the fact is that retail demand is subdued as reflected in the volumes of consumer-oriented companies. Also, Governor Shaktikanta Das’s observation that the transmission of the rise in policy rates is incomplete merits some attention. Das noted that the 250-bps hike over the past year or so has thus far resulted in an increase in the weighted average lending rate on fresh loans of just 169 bps. If rates go up, it could curb demand for loans. The really big concern is that with merchandise exports slowing sharply and services exports decelerating, a significant chunk of the economy isn’t doing well and could prove a drag on the economy and jobs. At this point, the 6.5% forecast seems optimistic. However, the bigger challenge for India’s central bank right now is inflation.
