This policy, as anticipated, contained no significant unexpected components. The monetary policy stance of “withdrawal of accommodation” persisted, while policy rates remained unchanged. This policy was formulated against the backdrop of a declining inflation rate, namely vegetable prices. Additionally, the Governor stated that a positive aspect is that core inflation has been declining by 140 basis points since its zenith in January 2023.

In addition, the most recent survey of household inflation expectations indicates that expectations for inflation three months from now are down 90 basis points, while expectations for inflation one year from now are down 40 basis points. With demand recovering in the rural sector and remaining robust in the urban sector, the RBI characterizes growth as resilient. The overall development outlook for the year and FY25 remained unchanged at 6.5 percent.

Notwithstanding the aforementioned positive developments that have been emphasized regarding inflation dynamics, the RBI’s stance has not changed; its commentary and forthcoming guidance continue to be pessimistic. This can be attributed to the substantial levels of uncertainty that remain regarding inflation. Aspects of land sown with kharif pulses are deficient, kharif onion production requires close monitoring, and spice demand-supply mismatches are likely to persist. Significantly, the continuation and intensification of El Nino conditions are anticipated to exert an influence on worldwide food supplies and prices. September 2023 saw the FAO All Rice Price Index reach 141.7, a 0.5 percent month-over-month decline from August but a 27.8 percent increase compared to the index level at the same time last year.

I will attempt to situate the RBI’s monetary policy outlook within the global context in the following couple of paragraphs. A significant shift in the global rate environment has occurred. Commencing in 2003, the Fed Funds rate stood at 1 percent, a level not seen since the era of Alan Greenspan. The rates were subsequently grounded at zero percent in the United States during the tenure of Ben Bernanke and in the aftermath of the Great Recession of 2008.

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From that point forward until approximately June 2022, the US Fed Funds rate was, on average, lower than the CPI inflation rate. In contrast, the Fed Funds rate was nearly always higher than the prevailing rate of inflation between 1982 and 2002. To put it more simply, the United States economy had experienced prolonged periods of positive real interest rates prior to 2008. However, since the aftermath of the Global Financial Crisis (GFC), and continuing until very recently, the situation has been marked by negative real interest rates. This holds true regarding the ECB as well.

Currently, we are once again in the region of positive real interest rates. The most recent policy meeting of the US Federal Reserve outlined economic projections that continue to depict the economy’s resiliency. In accordance with the projections, the improved outlook also required the Fed to maintain a hawkish policy stance. Twelve members now anticipate a 25 basis point increase in interest rates by the US Federal Reserve in 2023, while seven others anticipate a hiatus. The dot plot now proposes a 50-bps reduction in interest rates for 2024, as opposed to the 100-bps reduction that was anticipated in the June projections. As a result, the message regarding “higher for longer” is unequivocal, and the Federal Reserve will maintain rates at restrictive levels for a longer duration than in prior cycles.

Significantly, the sanctity of the inflation target rate in monetary policy formulation is acquiring prominence on a global scale. The same holds true for India. As monetary policy communication becomes an increasingly significant instrument in managing and stabilizing inflation expectations, the Reserve Bank of India (RBI) reaffirms its commitment to attaining the 4 percent target consistently. The inflation forecasts published by the Reserve Bank of India (RBI) for the remainder of the year do not appear to indicate that the target of 4 percent cannot be met.

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In Q1FY25, the RBI anticipates headline CPI inflation of 5.2%. In addition, the RBI forecasts a CPI of 4.5 percent for the entire fiscal year of 2025, whereas YES Bank anticipates an average of 4.8 percent. Given the persistent evasion of the 4 percent handle, the Reserve Bank of India (RBI) faces significant challenges in even adopting a “neutral” monetary policy stance, let alone reducing the policy rate.

Thus, “higher for longer” continues to be applicable not only globally but also in the context of India. Additionally, it may prove challenging for the RBI to reduce interest rates prior to the US Federal Reserve, given that the interest differential between India and the US has shrunk to approximately 250 basis points, which is barely sufficient to offset the anticipated annual average depreciation of the INR. This interest disparity might continue to be significant for investors entering the Indian debt market, including those utilizing the JPM Bond Index inclusion route.

Bond market participants had not expected any modifications to the Reserve Bank of India’s liquidity strategy, particularly in light of the gradual reduction of the incremental cash reserve ratio (I-CRR). There were no additional measures specified in this policy. However, the RBI emphasizes once more that excessive liquidity can increase the hazards of inflation and financial instability.

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In doing so, the RBI reinstates the possibility of conducting open market operations (OMO) sales as a means of liquidity management. Although the likelihood of such OMOs being calendarized is low and would be contingent on changing liquidity conditions, the bond market has been alarmed nonetheless. As a result, the benchmark 10-year India G-sec yield has increased by approximately 12 basis points to 7.33 percent, and it may maintain its stability in the foreseeable future.

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CPI inflation increased to 4.8% in June 2023 from 4.3% in May 2023, but remained within the RBI’s acceptable range. The majority of the increase was attributable to a significant increase in food inflation, which rose to 4.6% from 3.3% a month earlier. Uneven monsoon and heatwave conditions have resulted in an abrupt increase in a few components of vegetable inflation. The sharp upward revision of near-term inflation projections (Q2FY24/Q3FY24 forecasts increased by 100bps/30bps to 6.2 percent/5.7 percent) is attributable to the food price risk. Although higher vegetable prices could pose an upward risk to CPI in the coming months, we believe this uptick is more transitory in nature and will subside in the second half of the fiscal year, per historical evidence. The RBI increased its CPI projection for FY24 from 5.1% to 5.4%.

After a delayed start, precipitation has increased; from a monsoon deficit in June to a 5 percent-above-average surplus in July. Recent IMD forecasts, however, indicate that August precipitation will be below normal (less than 94% of LPA). If the spatial distribution of rainfall remains asymmetrical, it could have a negative impact on kharif sowing and exacerbate food inflation in the future months. The recent increase in international crude oil prices as a result of supply decreases from OPEC+ countries could also increase imported inflation.

While food inflation is worrisome, the decline in WPI inflation is a source of solace. With a lag, the deflation of the WPI and the softening of the prices of many global commodities could provide some relief from the increasing inflationary pressures. Moreover, the moderation of core inflation provides additional solace. The core CPI fell to 5.1% in June of 23 and remains below the one-year average of 5.8%, reflecting the influence of past transmission on the real economy.

Studies have demonstrated that headline inflation follows the trend of core CPI, indicating that inflation dynamics are still under control. But the RBI is concerned about the impact on household inflationary expectations. In its statement, the MPC noted that these shocks are of a transient nature and can be disregarded for a period of time, unless there are repeated instances of food price shocks that pose a danger of anchoring inflation expectations. While the rainfall activity has acquired momentum, the temporal and spatial distribution of the same and a potential El Nio event would continue to be essential monitoring variables.

GST Collections, Corporate Tax Collections, and Income Tax Collections all indicate that India’s economic activity has remained resilient. Urban demand continues to be robust, with domestic air passenger traffic and household credit maintaining double-digit growth rates. The recovery of kharif sowing and rural incomes, as well as the buoyancy of services and consumer optimism, should boost household consumption. While high-end consumption and government capital expenditures are thriving, domestic demand and exports remain subdued.

The government’s emphasis on capital expenditure, higher capacity utilisation in the manufacturing sector, a moderation in commodity prices, and robust credit growth are growth stimulants. For FY24, the RBI has maintained its real GDP growth forecast at 6.5%. Significant hazards to GDP growth in FY24 include weaker global demand, geopolitical tensions, and the emergence of El Nino conditions.

Given the excess liquidity in the system, particularly as a result of the withdrawal of Rs 2000 notes, the RBI instructed scheduled banks to maintain an incremental CRR of 10 percent on the increase in their net demand and time liabilities (NDTL) between May 19, 2023 and July 28, 2023 in order to absorb the excess liquidity. As this announcement is negative for Banks in the short-term, the Bank Nifty fell following its release.

The impact of this announcement must be evaluated for each bank separately; the RBI will reconsider this decision by September 8 or earlier, based on the systemic liquidity levels preceding the holiday season. As the policy decision and commentary were essentially in line with expectations, the yield on India’s 10-year government bonds remained rangebound.

RBI is expected to keep a close eye on the inflation outlook and is intent on maintaining inflation expectations firmly rooted at its primary target of 4 percent, despite the difficulty of the task.

We believe that the central bank appears to be less concerned with growth than it is with inflation forecast uncertainty. In light of the recent rise in food prices, the likelihood of a rate cut increases. We anticipate a rate reduction in the first quarter of fiscal year 25 (Q1FY25), pending data.

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