RBI MPC meeting: Slowing rate hikes but unsure about the way ahead

A softer rate hike of 35 bps is justified against the backdrop of moderation in inflation despite it remaining above the upper limit of RBI’s inflation target band for 10 months in a row. Economic growth has remained resilient in the face of an adverse global environment. Inflation in most developed economies remains elevated but is showing signs of peaking.

Central Banks of most AEs and EMEs continued with their monetary tightening; although magnitude of rate hikes seems to have slowed. Indication of slowing down the pace of rate hikes by the US Fed Reserve might have taken the pressure off the MPC. Moreover, tightening the economy aggressively would run the risk of overshooting the repo rate, needed to achieve price stability. Although inflation persisted well above 6%; monetary policy rate hikes and its impact on inflation happen in lag. The impact of past rate hikes and liquidity tightening measures is yet to be seen. It may take 3-4 quarters for the policy rate to be transmitted to the real economy, and the peak effect may take as long as 5-6 quarters.

CPI inflation eased to 6.77% in October 2022 (3-month low) compared to 7.4% in September 22, supported by base effect even as food inflation kept headline inflation pushing higher, driven mainly by cereals and vegetables. High frequency data continues to indicate upside to prices of cereals, pulses, and vegetables. Healthy reservoir levels have aided a strong start to the rabi sowing season, auguring well for the prospects for output and prices. With the high base effect kicking in, the inflation numbers are expected to moderate in the coming months; although food price momentum could restrict the pace of fall.

Moderation in global commodity prices and domestic WPI inflation are comforting. Core inflation, which excludes volatile components such as food and fuel, persisted at elevated levels at 6%. The core CPI could remain sticky in the near term due to demand-driven pressures. Monetary policy is only able to influence demand and elevated core inflation, which supports further policy tightening. Since monetary policy typically works with a lag, further rate action would be data-dependent. Unchanged inflation forecast at 6.7% for FY23 (5%/5.4% in Q1FY24/Q2FY24) is reassuring with high average crude oil price of US$ 100 per barrel considered in this, providing a cushion. Also, the outlook for the US dollar and hence imported inflation remains uncertain. Headline inflation is expected to moderate from H1FY24, but still remains above the target.

India’s economy grew by 6.3% in Q2FY23 following a double-digit growth of 13.5% in Q1FY23, mainly on account of the normalization of the base and a contraction in the manufacturing sector’s output. Net exports are likely to come under further stress given the looming global slowdown, which would dent global demand. Recent forecast of the global economy showed a deteriorating global economic outlook. IMF expects one third of global GDP to enter contraction. Geopolitical uncertainty, synchronized monetary tightening, high energy prices is clearly weighing on global growth.

India’s economy, however, is growing at a steady pace on the back of strong fundamentals, as reflected by high frequency indicators. Auto sales, GST collection, e-way bill, PMI, credit growth continue to portray a healthy picture. In the agricultural sector, a pick-up in rabi sowing is supported by good progress of the north-east monsoon and above average reservoir levels.

Activity in the industry and services sectors is on an expansion mode, as reflected in purchasing managers’ indices (PMIs) and other high frequency indicators. Aggregate demand conditions have been supported by pent-up spending and discretionary expenditures during the festival season, although their evolution is somewhat uneven across sectors. Urban demand has remained buoyant, and rural demand is slowly recovering. Investment activity is in modest expansion. With favorable base effects disappearing, growth is expected to normalize over the coming quarters. RBI lowered the real GDP projection marginally from 7% to 6.8% for FY23 (7.1%/5.9% in Q1FY24/Q2FY24). Headwinds to the domestic economy would emanate from slowdown/recession spilling over and lagged impact of monetary policy tightening. Additionally, private sector capex is likely to be delayed, given the uncertain global and domestic demand conditions; especially during interest rates.

Apart from managing the growth-inflation dynamics, RBI seems to be mindful of the external sector imbalances. It has done a commendable job in containing volatility and ensuring orderly movement of the rupee through FX reserves. Although the RBI remains in absorption mode, it will conduct LAF operations that inject liquidity to meet the requirements.

Overall, the MPC policy was less dovish given that there was no change in stance; as against the market expectation. Reaction to that is seen in bond yields — 10-year Gsec yields moved up 5bps to 7.30%. Commodity prices have also come off and fall in crude prices is also encouraging. However, a sticky core inflation and higher cereal prices and increasing food inflation has kept RBI cautious. We expect the terminal policy rate would be 6.5% with the last 25 bps rate hike delivered in the February policy.

Rate hike in February 2023 would be dependent on global development, evolution of crude oil prices, additional inflation data and contours of FY24 Union Budget. RBI could allow the past rate hikes to reflect on the economy and desist from getting more hawkish, especially when MPC members have already expressed their view to await transmission to avoid overdoing hikes.

The author is Head of Retail Research, Securities

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