February RBI policy likely to focus on liquidity over rates

6 Feb 2024 , 11:13 AM

RBP MPC meeting commences on February 06, 2024

The RBI Monetary Policy Committee (MPC) will present its first monetary policy statement for 2024 on February 08, 2024. The 3-day MPC meet commences on February 06, 2024 and culminates in the presentation of the RBI policy on February 08, 2024. More than the policy statement, the markets will try to absorb the gist of the hints given by the RBI governor in his post-policy interaction. The policy comes in the aftermath of the Union Budget, and a week after the Fed policy statement. There is also the Q3 GDP expected on the last day of February. In short, there are a number of data points that the RBI will consider when it finalizes the policy statement.

In the past, the six members of the MPC (including the RBI governor) have preferred a gradual path to address inflation. Since September 2023, the CPI headline inflation has stayed below the outer tolerance limit of 6%. However, the inflation has been erratic and has shown a tendency to veer away from the 4% target on a persistent basis. In India, it is not so much the core inflation or the fuel inflation that is applying pressure. It is the food inflation, led by pulses and cereals, causing a spike in inflation in recent months. In this period, core inflation has trended lower as supply chain issues get addressed.

Macro build-up to the February RBI monetary policy

To understand the expectations ahead of the monetary policy statement, it is essential to look at the macroeconomic backdrop in which the policy is being presented.

1. The February monetary policy comes just after the presentation of the Interim Budget on February 01, 2024. The interim budget is normally seen as the semi-final before the final budget, but the interim budget had two major implications for monetary policy. Firstly, the fiscal deficit estimate for FY24 has been cut by 10 bps to 5.8%. At the same time, the FY25 fiscal deficit has been pegged at 5.1%; sharply lower than the street estimates of 5.3% to 5.5%. Secondly, the logical outcome is that the borrowing program for FY25 is also going to be more benign and that has dovish bond yield implications.

    

2. The US Fed policy, that was announced just a day ahead of the Interim Budget, has maintained status quo on rates. However, the Fed chair has ruled out any rate cuts even in the March policy meet. That means; the US markets can only hope for a rate cut, either in the May 2024 or in the June 2024 policy. The Fed has been accused of being too paranoid about inflation, but obviously the central bank knows best. It also means that the RBI will not be in a hurry to cut rates for now.

    

3. The Indian economy is just about 2-3 months away from a general election. Political equations are hard to predict, but the interim budget has given hope that fiscal prudence will be the name of the game and that infrastructure spending will not be compromised. Liquidity increases in the economy during elections and the RBI February policy would be conscious of that. The next RBI policy will be around the election time.

    

4. The US economy appears to have managed a soft landing. Even after the spate of rate hikes and the Fed balance sheet unwinding by $1.5 trillion, the US GDP growth continues to be robust. In fact, the first advance estimate of Q4 GDP in the US has been pegged 120 bps above expectation at 3.3%. Even the Atlanta Fed GDP projections for Q1 are now pegged 120 bps higher at 4.2%. While the Fed may not confirm a soft landing, it does look like the US has well and truly avoided the hard landing risk.

    

5. Finally, as India awaits the all-important Q3 GDP numbers on the last day of February, the big challenge today is geopolitical. The unrest caused by the Houthi rebels in the Red Sea has seriously disrupted the most important trade route through the Suez Canal. For India, the impact on merchandise exports is estimated at $30 billion and that could have implications for the level of current account deficit for FY24.

It is in this backdrop that the RBI Monetary Policy Committee will announce the first monetary policy of the calendar year on February 08, 2024. Here is what to expect.

Will the RBI tweak repo rates in February 2024?

RBI has kept rates at the current level of 6.5% since February 2023. Hence, there is no immediate incentive for the RBI to hike rates. Agreed, food inflation is persistent, but for that rate hike is not the answer. Also, the negative impact on cost of borrowings due to higher rates may negate any benefits that could possibly accrue from lower inflation. On a net basis, there is hardly a case for rate hikes at this juncture. What about rate cuts? In the last few months, the inflation has veered farther from the 4% target and closer to the 6% outer tolerance limit. It may not be disconcerting, but warrants caution, nevertheless.

The January inflation is yet to be announced but it is expected to be around the December level of 5.69%. it would be hard for the RBI to justify a rate cut at this juncture, especially when the Fed is also going slow on rate cuts. To add to the macro risks, the situation in the Red Sea is likely to intensify inflation pressures. At the same time, the weak Kharif and Rabi in 2023 is already putting pressure on food prices. For now, the RBI may just leave the repo rates as it is. That means; the connected rates like the SDF rate and the MSF / Bank Rate will also maintain status quo for now.

Is it time for RBI to change its monetary stance?

MPC members like Jayanth Varma have persistently questioned the current monetary stance of “gradual withdrawal of accommodation.” According to Varma, there was no point in having a stance to withdraw accommodation at a time when the overall financial system has been under a liquidity shortfall for the last 3 months. However, the argument of the RBI has been that this liquidity shortfall is temporary and would improve once the election spending and churning starts around March this year. 

The question has been adequately answered in a recent note put out by SBI Research. According to the report, the liquidity short fall of nearly Rs3 trillion does not require any change of monetary stance. Instead, what the RBI is likely to do is to give an indication that the RBI would be willing to back the banking system with alternate measures to infuse liquidity. Hence, for now, the RBI may still maintain its stance of “Gradual Withdrawal of Accommodation.” A shift to a neutral or dovish stance at this point may be uncalled for.

Will RBI hike inflation target in the February 2024 policy?

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 and the December policy, the RBI had maintained status quo on inflation projections at 5.4%. On the inflation front, the RBI would still be wary of imported inflation, rupee weakness and the stickiness of specific products in the food basket like cereals, pulses, and milk. The Red Sea crisis has also  added a layer of inflation risk to the Indian economy. 

However, global commodity prices are still under pressure and that is keeping the cost-push factors under check. While inflation in December touched 5.69%, it is still under the 6% outer tolerance limit. Hence, RBI may not see any immediate need to change the inflation projection for FY24 from the current estimate of 5.4%. A marginal increase cannot be totally ruled out; although the RBI will take comfort from the persistently lower core inflation.

Can we expect another GDP estimate upgrade for FY24?

In the December 2023 policy statement, the RBI had hiked its GDP growth outlook for FY24 by 50 bps from 6.5% to 7.0%. Between the December policy and the February policy, there has not been any additional GDP reading. The Q3 GDP estimates by MOSPI are only expected on the last day of February 2024. Hence, the RBI may choose to also maintain status quo on its GDP growth projections, in the February policy. The RBI estimate is already well above the estimates of the World Bank, IMF, and the OECD and hence the RBI would rather wait and watch for now. The important point to remember is that the government has invested aggressively in capex in the last 3 years. Even in the interim budget, the government has pegged capex at 3.4% of GDP. The cumulative lag effective of such capex is likely to have a salutary effect on GDP growth in FY24 and FY25.

Will the RBI focus on liquidity management in the February policy?

That looks like the most plausible scenario. With a status quo on repo rates, stance, inflation projections and GDP growth projections; liquidity has been the one big factor to watch. The markets will be closely tracking the RBI language on liquidity and any kind of liquidity management measures. The liquidity deficit had touched a recent peak of Rs3.50 trillion on the back of advance tax payouts GST payouts and the delayed capex and revenue spending by the government this year, in order to keep fiscal deficit in check. However, the upcoming elections will most likely infuse a lot of liquidity in the system.

For now, RBI may focus on giving comfort to the market that it is willing to stand behind the market players to ensure adequate liquidity.  Firstly, there could be a clear articulation by the RBI in the policy statement that it would be open to cutting the CRR (cash reserve ratio) and the LRR (legal reserve ratio) beyond a certain threshold on an automatic basis. That should be good enough. In addition, the RBI may also define guidelines as part its supplementary policy note on the conditions under which such facilities may be triggered.

Addressing the credit deposit dichotomy

In the last few months, a major overhang for the banks has been the rising premium of the growth in credit over the growth in deposits. In short, the deposits are just not growing fast enough to keep pace with the demand for credit. In the last quarter, agriculture credit and MSME credit have seen good growth even as the RBI has intervened to curb consumer lending. Such dichotomies are outside the purview of the policy statement. Hence, it is very likely that the supplementary note of the RBI policy statement may contain measures to bridge this gap between banking credit and bank deposit growth.

Finally, will the RBI provide outlook on rate cut timetable

One thing that is apparent in the last few policy statements is that the RBI may have already peaked on its repo rate trajectory at 6.5%. Obviously, RBI may not be able to give explicit affirmation on this front, but the actions of the RBI, even in the midst of the sharp spike in Inflation post July 2023 is testimony to this viewpoint. However, any outlook on rate cut trajectory may be premature at this juncture and that should not be expected. Unlike the Fed, the RBI does not give longer term projections considering the volatile nature of prices and liquidity in India. Hence, any forward guidance on rates trajectory looks unlike in the February policy statement. However, the message that has come from the RBI in the past policy statements is that the rate cuts may happen around August 2024, after the monsoon impact on Kharif output is clear.

There are two areas the RBI may explore in February. One is ways to make the rupee more robust and stable on auto mode, without persistent RBI intervention. The second could pertain to how the RBI tweaks the mix of loans of banks and NBFCs from the consumer perspective. For the final word, we have to await the actual policy on February 08, 2023.