By Renu Kohli
At an annual 5.1%, June’s Consumer Price Index (CPI) inflation was a little higher than consensus expectations (4.8%). Indeed, the last stretch of disinflation is not just proving to be gradual and protracted, but increasingly frustrating as well. The prime culprit, if described so, food inflation, has continued to firm up; with uneven monsoons, the future seems more uncertain than many analysts would like to believe. This would certainly dampen any expectation of an early rate cut, as governor Shaktikanta Das recently cautioned against any hasty action. Thus, high real interest rates — 2% or above 3% if measured vis-à-vis core inflation — will inevitably persist for much longer and possibly extract a larger growth sacrifice as two dissenting Monetary Policy Committee (MPC) members (JR Varma and A Goyal) apprehended at the last review meeting.
Should the other MPC members review their hawkish position on food inflation? A legitimate question could be this: If headline CPI inflation remains well-anchored, core inflation is sub-target (<4%), and there is very little sign of food inflation spilling to the core, then why the hesitation? Are there other factors driving caution, especially in the Reserve Bank of India (RBI) leadership?
We would like to deliberate if financial stability concerns have become more critical for the central bank than is publicly acknowledged. While financial sector-related issues are not in the MPC’s remit, the RBI has a dual role to perform, delicately maintaining a balance between the two concerns. The recent weeks have seen several news reports of how the RBI is cautioning commercial banks to keep tabs on the tight credit-deposit ratio. According to the central bank data, the aggregate C-D ratio was ~78% in mid-June, as bank deposit growth lagged that of credit. Such a situation is simply not sustainable because banks would compete for deposits, thereby raising the costs, which would be counterintuitive at a time when the MPC is waiting to ease the policy rate.
Imagine the sheer anomaly if indeed the MPC decides to cut the policy or repo rate. Because a large and growing share of retail assets are benchmarked to the repo rate, banks will have to pass on the new and lower rate to existing customers. If unable to achieve a commensurate reduction in their cost of funds, or lower deposit rates, their margins will suffer; quite likely, this may compel them to increase risk premium on fresh loans, thus slowing or even completely blocking the transmission of monetary policy. In the worst-case scenario, some banks may even be pushed into a very tight corner, necessitating an increase in their effective lending rates, a counterproductive outcome.
How have things come to such a pass? Benchmarking lending rates to a policy variable has an inherent risk with structural rigidities in the banking sector. Problems could magnify because of several asymmetries and imbalances in key macro variables, especially buoyant asset prices and markets coexisting with declining financial savings. This complicates the central bankers’ task, especially assessing what is an acceptable real rate to restore the demand-supply mismatch!
What could the RBI do? The central bank has already imposed some macroprudential measures to slow the galloping retail loans, check bank credit to the non-banking financial companies, and it must possibly be monitoring the impact. But any hurry to encourage wholesale credit by lowering lending rates could complicate the situation. Certainly, macroprudential policies will not be effective if operating at cross purposes with monetary policy action. The two must be aligned.
This delicate situation is further complicated by slowing foreign capital inflow. A persistent decline in net foreign direct investment (FDI), the bedrock for current account financing for several years, has arisen as the new pressure point in India’s external account. While the narrowed current account gap is a positive recent development, the $9.8 billion net FDI received in 2023-24 was a multi-year low and could become a source of concern. The significance of portfolio inflow in India’s external account has become more critical as a result. While its equity component has been volatile and beyond the RBI’s policy space, the central bank could be finding it difficult to delink itself from the monetary policy cycle of advanced economies, especially the US Federal Reserve.
Despite India’s inclusion in the JP Morgan Emerging Market Bond Index from June 28, fresh foreign institutional investor investments in the bond market have been underwhelming so far. Market expectations are that these will gather momentum as India’s weight will increase by a percentage point each month to reach the 10% cap by March 31, 2025. The RBI could be carefully evaluating if any rate action would throw a spanner in this wheel. What is important to note here is that falling FDI could have inadvertently caused some degree of loss in the independence of the monetary policy setting, focusing exclusively on domestic factors.
While the RBI has been alert and keenly minded about these developments, resilient growth has allowed it the time and space for bringing inflation closer to target on a durable basis with core inflation well-anchored. However, there are incipient signs of global commodity prices firming up, domestic producer prices gaining some momentum, pushing up input costs, and, in forthcoming months, pressuring corporate margins. In a protected economy and oligopolistic market structure where dominant players can set prices, the risk of rising wholesale prices spilling to retail ones could be much quicker. Further, if the government chooses to focus on reviving consumption and freeing petroleum retail prices in the Budget, there could be upside risks to the RBI’s inflation forecast for FY25 and FY26.
In an economy that displays signs of growth anxiety, the RBI has been adroit in managing expectations. However, if the growth outcome turns out slower than projected, the room to manoeuvre will disappear faster. The central bank must be wishing food prices to normalise soon although the clouds appear thicker in the horizon.
(The author is the senior fellow at the Centre for Social and Economic Progress, New Delhi. Views expressed in the article are personal views of the author.)