Samiran Chakraborty, Chief economist India, Citigroup Global Markets

A consumption-focused Budget with larger than expected personal income tax adjustments now sets the stage for monetary policy to take over in the February Monetary Policy Committee (MPC) meeting. But before we delve into what policy considerations could be in front of the MPC, it is important to make a fair assessment of the macro backdrop.

The sharp deceleration in Q2FY25 gross domestic product (GDP) growth to 5.4% was worrying, but there is sequential improvement in growth in the third quarter with clear signs of bottoming in economic activity from October. At the same time, the pace of improvement could have been lower than what we had anticipated earlier. In our view, Q3 GDP growth is now tracking around 6%. It implies that the asking run rate for Q4 could be closer to 7.5% for the full-year GDP growth to come in at the Central Statistical Office’s estimate of 6.4%.

While this appears to be a tall ask, we are optimistic that the 95% year-on-year growth in central government capex for December 2024 will improve the cash flow in the economy and act as a mini-stimulus for different kinds of economic activities which are connected to public capex. Moreover, the revised estimates of FY25 central government capex indicates that Q4 growth could be 21% and add to the policy impetus.

However, the performance of the growth drivers has not been uniform. Urban and rural consumption growth continues to diverge and private investment has been sluggish. While most of the consumer-facing companies on the goods side are reporting weak demand conditions, we also note through our e-commerce app usage tracker that growth in online spending has been reasonably good — averaging 18% in the October-December quarter. Also, there appears to be a distinction between demand for goods and demand for services with the latter holding up better.

Given our understanding of the macro backdrop and the fiscal policy steps which are already in motion, we think that at this point a “policy nudge” from the MPC might be good enough to bring the economy back on track rather than a big “policy boost”. Monetary policy is mostly a cyclical tool and at this juncture should be employed to arrest any risk of an early cycle slowdown from decelerating further. A relatively conservative fiscal policy stance of the government also provides the space for monetary easing.

On top of that, January inflation is tracking at comfortably below 4.5% given the steep drop in vegetable prices and some broad-based decline in other food items like milk/edible oils/sugar/pulses. There is now a small downside risk to the RBI’s January-March quarter inflation forecast. We expect FY26 average headline consumer price index (CPI) at 4.2%, especially if oil prices moderate further. It appears that the RBI would have better visibility of headline CPI aligning towards the 4% medium-term target which would be a key factor behind policy easing.

Monetary policy easing could potentially happen through four steps — liquidity, rates, macro prudential measures, and some exchange rate depreciation. Out of these, the last one on currency depreciation is already on its way, both in terms of nominal as well as real valuation adjustments.

For better transmission of monetary policy, the RBI has already announced some durable liquidity infusion measures including open market operation purchase, FX swaps, and longer-duration variable rate repo. These interventions will be commensurate with the RBI’s current “neutral” monetary policy stance. The nature of the liquidity announcement measures — diversified and providing predictability — makes us hopeful that the RBI will proactively avoid another situation of durable liquidity turning negative.

As such, they also indicate that the RBI is creating the right preconditions for rate easing. Consequently, in our base case, we see a possibility of further liquidity infusion by the RBI in late February/early March, with the quantum dependent on how the balance of payments situation turns out to be. Theoretically, it is the correct position that in an inflation targeting regime with interest rate being the operating tool, the RBI shouldn’t have an independent liquidity target. In practice, without visibility on durable liquidity, the transmission of monetary policy might be delayed.

Apart from the liquidity infusion, rate easing cycle could be started with a 25 basis point (bps) repo rate cut in the February policy. The government’s fiscal consolidation path is likely to lead to 20-30 bps negative fiscal impulse according to our estimates, and hence there is space for monetary policy to be supportive. Forward-looking inflation is appearing to be aligning with the 4% target more comfortably now, giving us scope to start easing even before actual inflation prints drop to 4%.

While it might be too early to relax the counter-cyclical macro prudential measures formally, it might be comforting for the markets if the RBI can signal that its concern around the higher than usual credit growth in certain pockets has moderated.

The focus on the February policy will also be on assessing the quantum of rate cuts expected in this cycle. In that context, markets would like to glean from the statement whether there are any changes in the RBI’s views around issues like weightage of inflation and growth in deciding the policy outcome, core versus headline inflation, and the neutral policy rate.

One of the arguments against monetary policy easing at this juncture has been the risk of further depreciation pressure on the currency. We think that capital flows into India are more growth-sensitive than interest rate-sensitive. Hence, if monetary policy can spur growth expectations now with modest easing, then in turn it can encourage equity inflows and support the currency. At this juncture, investors acknowledge that there is space for policy easing and believe that it will not destabilise our hard-earned macro stability.

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