December 2023 Monetary Policy likely to hold repo rates at 6.5%

8 Dec 2023 , 10:36 AM

The RBI Monetary Policy Committee (MPC) will meet for the last monetary policy of 2023 between December 06, 2023 and December 08, 2023. This 3-day meeting will culminate in the policy statement on Friday, December 08, 2023; which will be the preceded by the RBI government making a detailed statement and interacting with the members of the press. It may be recollected that between May 2022 and February 2023, the Fed had hiked repo rates by 250 bps from 4.00% to 6.50%. However, since the February 2023 policy, the RBI chose to maintain status quo on rates, and it has stayed at 6.50%, as have the linked rates.

There have been several developments in the last two months since the October policy, that have given comfort to the RBI. Firstly, the inflation has receded sharply from a high of 7.44% in July 2023 to 4.87% in October 2023. The November inflation is expected around the middle of December, so that will be known only after this monetary policy. However, no negative surprises are expected on the inflation front with food inflation largely reined in and fuel inflation tapering in line with global Brent Crude prices. Before we get into the expectations for the December 2023 monetary policy, here is a run-down on the macro backdrop in which the December monetary policy will be presented by the RBI.

Macro backdrop for the December 2023 monetary policy

If you look at some of the key developments since the October policy, they have all pointed towards monetary conditions easing and prices tapering. Here is the backdrop.

1. The big trigger for the RBI policy statement on December 08, 2023 will be the GDP numbers for Q2 that have just been announced at 7.6%. That is nearly 80 bps higher than the consensus street expectation. In addition, the nominal GDP growth rate came in at 9.1%, which is higher than the first quarter, showing that but for higher inflation, the real growth story would have been much better. In retrospect, the RBI had halted rate hikes to reduce the solvency risk for corporates. That seems to have worked.

    

2. India inflation has been on a consistent downwards trend. After touching a current year peak of 7.44%, the headline inflation has steadily fallen back to 4.87%. The real villain of the piece had been food inflation and that is under control. One can argue that inflation in pulses and cereals is still too high, but that is more due to the supply chain constraints. More importantly, fuel inflation and core inflation are sharply lower, which is indicative of the fact that there could be more downsides to inflation reading.

    

3. The US bond yields and the US dollar index have sobered in the last two months. The US dollar index (DXY) had crossed the levels of 107 recently; only the third time in the last 40 years. However, with the prospects of more rate hikes by the Fed gradually waning, the lower dollar index may be here to stay and that is positive for the INR. Also, with the CME Fedwatch turning increasingly dovish, the US bond yields have fallen in tandem. This has reduced the pressure on Indian bond yields.

    

4. Core sector growth in India flattered at 12.07% for October 2023. However, that is just part of the story. For five months in succession, the core sector (infrastructure) growth has been above 8%, something we have not seen in a long time. Out of these 5 months, the core sector growth was higher in two of these months. The sharp surge in core sector growth is led by coal, power, cement, and steel; largely a reflection of the downstream impact of the aggressive capex by the government of India.

    

5. Finally, it is the US Goldilocks effect that will be the deciding factor when the RBI meets for the December monetary policy. The US GDP has grown at 5.2% in the third quarter and the full year promises to be closer to 2.5%. Also, the US inflation is trending towards 2% target, slowly and surely. As the CME Fedwatch has been reflecting, irrespective of what Jerome Powell says in his speeches, the Fed really does not have any strong incentive to hike rates from these levels.

It is in this backdrop that the RBI Monetary Policy Committee is likely to announce the last monetary policy of 2023 on December 08, 2023. Here is what to expect from the policy.

Will the RBI tweak the repo rates in December 2023?

To begin with, rate hikes are ruled out, as the central bank really has no reason to hike rates at this level. The other question is whether the RBI would cut rates in the December policy. At this juncture it looks very unlikely since inflation has just about come under control. Therefore, it is very likely that the RBI would just let rates be as it is. At 6.5%, the RBI has done enough tightening and would rather believe that the lag effect of rate hikes should take care of the remaining inflation risk in the economy. The inflation risk in the last few months has largely stemmed from food prices and that is fairly under control. Kharif production this year has been below par and a lot will hinge on how the Rabi season delivers. Since the food inflation is still there in the horizon, the RBI may not consider any major tweaks to the interest rates at this point of time. 

Why will the RBI not cut rates with inflation having fallen so sharply. Firstly, the RBI would like to be convinced that the fall in inflation is secular rather than cyclical. That confirmation is still not there. Secondly, the RBI would not want to cut rates when the target inflation rate is still about 90-100 bps away. More so in the light of the fact that the Fed continues to maintain a hawkish stance. Thirdly, the current rates are not putting any pressure on macroeconomic growth as is evident from the GDP numbers and the corporate results for Q2. RBI may also look at a new normal for rates. Lastly, RBI will like to sequency its action. RBI will first shift its monetary stance and then follow it up with rate cuts, if at all.

Will the RBI change its monetary stance in the December policy?

The RBI has maintained its monetary stance at “gradual withdrawal of accommodation” for some time now. However, there are several developments that may impel the RBI to take a relook at its monetary stance. One of the MPC members, JR Verma, has been consistently pointing out that the current stance did not really gel with what the RBI was trying to do and the intent of the current policy. For instance, withdrawal of accommodation is not in sync with the rising demands that the RBI must be cutting repo rates in the light of sharply lower inflation. Secondly, the Indian money markets have been under a severe liquidity deficit for the last few weeks. In these conditions, it would not add too much value to focus on withdrawal of accommodation when the RBI is likely to infuse liquidity into the system. 

The issue of change of monetary stance is not about the decision but the timing. It is unclear whether the RBI would undertake such a critical move in this meeting or perhaps the February meeting. However, change of stance is a discussion that is long overdue. One can expect that, even if the RBI does not immediately shift its stance from “withdrawal of accommodation to neutral” in this policy, it would give sufficient hints and guidance of what it plans do on the stance front in the coming months. After all, the current RBI governor takes the job of communication very seriously at the RBI.

Will the inflation estimates be tweaked in the December policy?

On the inflation front, it may be recollected that the RBI had hiked the inflation target for FY24 by 30 basis points from 5.1% to 5.4% in its August monetary policy. However, in the October policy, the RBI had maintained status quo on inflation at 5.4%. In terms of next four quarters; the RBI has projected inflation for Q2FY24 at 6.4%, Q3FY24 at 5.6%, Q4FY24 at 5.2% and Q1FY25 at 5.2%. On the inflation front, the RBI would still be wary of imported inflation, rupee weakness and the sticky inflation of specific products in the food basket like cereals, pulses, and milk. Also, the latest OPEC meet has resulted in the members cutting supply by another 1 million barrels per day. That is again likely to make the oil market undersupplied and raise prices. Higher crude means higher crude inflation and higher imported inflation as 85% of the crude needs are imported by India. Clearly, there is no incentive for the RBI to cut inflation expectations at this juncture. Inflation at 5.4% looks closer to what India may end up with in FY24. 

Will the RBI revise its GDP estimates upward?

That looks like the one segment of the RBI estimates that is likely to change. In the October 2023 monetary policy, the RBI had held the GDP growth projection for FY24 at 6.5%. The quarterly break up of the GDP growth estimates for the next four quarters was as follows: Q2FY24 at 6.5%, Q3FY24 at 6.5%, Q4FY24 at 6.0% and Q1FY25 at 5.7%. However, the latest GDP reading is likely to change the mind of the RBI. For instance, the GDP growth has come in at 7.8% in the first quarter and 7.6% in the second quarter. With inflation sobering, the real growth is likely to benefit. The current estimates of 6.5% GDP assume a very pessimistic growth story in the third and fourth quarter. 

However, if one looks at the core sector growth, a key lead indicator for IIP and GDP, then the future GDP growth numbers could still be robust. Government is spending a lot of its time and energy on boosting capex and being business-friendly. That will reflect in GDP growth, so the RBI has a very strong incentive to upgrade the GDP growth estimate for FY24 to closer to 7%. Whether the GDP growth upgrade is done in one go, or in phases, remains to be seen. Any growth upgrade by RBI will impel a slew of other growth upgrades from brokers, rating agencies and multilateral funding agencies. 

How will the RBI handle liquidity management?

The markets would be closely tracking the language of the RBI and the liquidity management measures. In recent weeks, several factors have contributed to the tight liquidity in the system. Advance tax payouts and GST payouts have absorbed a lot of the liquidity in the market. The incremental benefits of withdrawal of I-CRR and the withdrawal of the Rs2,000 denomination notes have already been factored into the liquidity assumptions. Despite that, the liquidity situation in the financial market continues to be tight and the RBI would most likely be part of a slew of market easing measures. These may be announced as supplementary measures.

Finally, will the RBI commit on terminal rates

Markets are expecting the RBI to give hints on the terminal rate of interest or the level at which the RBI will call a stop to rate hikes. That is unlikely to happen at a time when the domestic situation and the global situation are quite fluid. The RBI would be cautious about liquidity with the big general elections coming up in around 5 months. The best commitment one can expect from the RBI on terminal rates is a broad guidance. With global monetary equations still fluid, obviously the RBI will want to keep its monetary options open and also play its cards close to its chest. While markets are assuming that the worst of rate hikes are done, the RBI is unlikely to give any such hints.

Two areas the RBI may explore is making the rupee more robust globally and also handling the aftermath of the tightening of consumer loans through higher capital adequacy requirements. We must wait for the actual policy on December 08, 2023.