RBI holds repo rates at 6.5%; blames it on sticky food inflation

8 Aug 2024 , 01:06 PM

WHAT HAS CHANGED SINCE THE JUNE 2024 MONETARY POLICY

When the June 2024 monetary policy was announced by the RBI, Indian polity was in a state of flux. The NDA had been voted as the largest combination but the government formation and the vote of confidence was yet to happen. Fortunately, things went on smoothly, and the polity did not encroach too much on economics. Between the two policy statements, there were 4 key data points. Firstly, the FY25 current account deficit (CAD) was announced towards the end of June, which was sharply lower at 0.7% of GDP. In fact, Q4FY24 saw a current account surplus. Secondly, the full budget on July 23, 2024 cut fiscal deficit target for FY25 by another 20 bps to 4.9% of GDP. However, higher allocations to Bihar and AP and a higher food subsidy bill raised concerns about defending the fiscal deficit target.

The biggest event in the intervening period between the June policy and the August policy was the July 31 meeting of the Federal Reserve. While the Fed broadly kept status quo on rates, the post policy conference by Fed chair, Jerome Powell, gave the first indication that the Fed may cut rates by 25 bps in September. The CME Fedwatch is building hopes of 2-3 would cuts in September 2024 due to a likely slowdown in the US economy, although the Fed has discouraged such ideas. The last big event in this period was the decision by the Bank of Japan to raise rates from -0.10% to +0.25%. This led to hardening of the Yen, putting currencies and markets in turmoil due to the unwinding of yen carry trades. It is in this backdrop, that the August 2024 monetary policy statement was presented by the RBI.

MISSED OPPORTUNITY – NOT ENOUGH FOCUS ON RUPEE AND BANK DEPOSITS

One would have logically expected a lot more focus on the Indian rupee and the quality of banking deposits. However, barring a brief mention in the governor’s speech, there was no mention even in the Statement of Development and Regulatory Policies. The first area of concern is the pace at which the rupee is weakening. In recent weeks, the rupee has not only weakened 13% against the Yen but even the USDINR is now closing in on ₹84/$. FPI flows have been volatile and trade deficit has widened. With the ongoing standoff between Israel and Iran, oil prices continue to edge higher at every opportunity. Things could get worse if Russia also cuts oil supply. In this context, one would have expected a much bigger focus on steadying the Indian rupee. Remember, historical experience has been that the weak rupee does not offer too much solace in terms of boosting exports.

The other concern was the risk of asset liability mismatch in bank liabilities. If you look at the numbers of banks in the latest quarter, what stands out is the falling CASA (current and savings account) ratio. For a long time, CASA offered the staple source of low-cost, stable liabilities for banks. With other lucrative avenues available, retail households are reducing focus on CASA. The result is that banks have to either raise long term fixed deposits, which come at a higher cost; or rely on Certificates of deposits (CD), which are short-term source of funds. Effectively, banks need a drastic rethink on their funding sources as they either risk lower NIMs or higher ALM risk. It is a choice between the devil and the deep sea.

HIGHLIGHTS OF THE RBI POLICY STATEMENT – AUGUST 2024

The RBI maintained status quo on rates for the 9th successive MPC meet. However, status quo was across other data points too. Here are key takeaways from the MPC statement.

• RBI held repo rates at 6.50% for the ninth policy in succession. The last time the repo rates were hiked was in February 2023. Currently, the repo rates are 135 bps above the pre-pandemic level of 5.15%; while real rates are around 2%, even with 5% inflation. Out of the 6 members in the MPC, 4 members voted to hold repo rates at 6.50%, while Jayanth Varma and Ashima Goyal voted to cut rates by 25 bps.
• Contrary to expectations of a shift in stance in some quarters, the RBI maintained its monetary stance of “Gradual Withdrawal of Accommodation” in the August 2024 policy. Between June and July, the financial markets moved from being liquidity-deficit to liquidity surplus and that could have triggered the status quo. Again, Jayanth Varma and Ashima Goyal voted for a shift to Neutral stance. These are two dissenting voices for two meetings in a row. Incidentally, both Jayanth Varma and Ashima Goyal are completing their 4-year term and will not be part of the October 2024 MPC meeting.
• During the current fiscal FY25, the liquidity situation moved from surplus to deficit and again back to surplus in early July 2024. System liquidity moved from deficit of ₹0.45 Trillion in June 2024 to a surplus of ₹1.10 Trillion in July 2024 and further to a surplus of ₹2.70 Trillion in the first week of August 2024. With the liquidity turning to surplus in July, the RBI shifted its strategy from injecting liquidity via VRR (variable rate repos) in June 2024 to mopping up liquidity via VRRR (variable rate reverse repos) in July 2024. The full budget announcement and the higher government spending has been largely responsible for the improving liquidity conditions in the financial markets.
• What does this rate decision mean for linked rates of RBI. With repo rates held at 6.5%, the SDF (standing deposit facility) rate, erstwhile reverse repo rate, stays pegged at 6.25% (25 basis points below the repo rate). The bank rate and marginal standing facility (MSF) rate stay pegged at 6.75% (25 bps above repo rates).
• In the June policy statement, the RBI had upgraded the GDP growth estimate for FY25 by 20 bps from 7.0% to 7.2%. That was lower than expected as the street was expecting 50 bps upgrade, considering the healthy ICOR (incremental capital output ratio). However, the RBI had opted to err on the side of caution. In the latest policy statement, RBI has stated that 7.2% looks achievable considering the solid progress in the Southwest Monsoons, improving rural demand, and robust manufacturing and services PMI (Purchase Manager Index). That is likely to help India stay the course as the fastest growing large economy for the fourth year in a row.
• What about inflation forecast? The forecast for FY25 stand at 4.5%. That already means, the RBI expects meaningful downsides in inflation in the second half of FY25, since the average inflation in FY25 till date is close to 5%. There were some concerns that the RBI may raise inflation forecast from 4.50% to 4.75% levels; to reflect the lag effect of food inflation, turmoil in West Asia and the risk of imported inflation due to the weak rupee. It is likely that RBI may take a final call on full year inflation in the October MPC meeting, after the monsoon and Kharif picture is a lot clearer.
• The RBI remained ambivalent about the timing and extent of rate cuts in the coming months. Today, there are diverse views on the rate trajectory. One perspective is that the RBI will not embark on rate cuts till it has food inflation in control. That means, it will need a consolidated picture of Kharif and Rabi; so, any rate cut in 2024 may be ruled out. Secondly, there is the more pragmatic argument that India growing GDP at over 8% in FY24 is testimony to the fact that the current rates are not hurting output. Hence, the status quo on rates may continue purely because the RBI can afford to keep its options loaded. The truth may lie somewhere in the middle. Most likely, the RBI is watching the outcome of the Fed meeting in September for signals on interest rates. If the Fed goes aggressive on rate cuts due to US growth concerns, it is likely the RBI may follow suit.

While the ECB has gone ahead and cut rates, the US Fed may be tracking Bank of Japan closely. The BOJ just hiked interest rates, something that can weigh on the Fed decision.

RBI HOLDS INFLATION PEG FOR FY25 AT 4.5%

Headline inflation had moderated but bounced back above 5% in June 2024 with strong food price momentum. However, favourable base effects are likely to tame inflation in the second quarter of FY25, but edge up in Q3 as the base effect wanes. The pick-up in kharif sowing, robust foodgrain buffer stocks and easing global food prices are positives for prices. Crude oil prices are volatile on demand concerns and geopolitical tensions, but traders are still bullish on oil. The recent mobile tariff hike is also likely to push up core inflation. Also, a pick-up in selling prices in second half of FY25 will also be inflationary. Incidentally, inflation expectations of households has gone up and consumer confidence has weakened.

There are several headwinds to inflation. Geopolitical tensions are still high, Iran / Israel are on the brink of war, and global commodity prices are still volatile. Volatile international commodity prices may continue and India is facing inflation headwinds from a strong Yen and the deteriorating political situation in neighbouring Bangladesh. In view of the diverse pressures, the RBI has held its inflation projection for FY25 at 4.5%. In terms of next four quarters; the RBI has projected inflation for Q2FY25 at 4.4%, Q3FY25 at 4.7%, Q4FY25 at 4.3%, and Q1FY26 at 4.4%. RBI expects rapid normalization of food inflation in Q2FY25.

RBI HOLDS GDP GROWTH ESTIMATE AT 7.2% FOR FY25

With FY24 GDP growth better than expected at 8.2%, the June policy statement had raised the growth projection for FY25 from 7.0% to 7.2%. However, in the August policy statement, the growth estimate has been maintained for FY25 GDP at 7.2%. On the positive side, the above-normal monsoons and healthy kharif sowing will support rural demand. While the start to monsoons was tepid, it has caught up in July and August to normal levels. However, some of the key crop producing states like Bihar, Jharkhand, Punjab, and Haryana are still deeply rainfall deficit. While macro crop concerns have reduced, there are positive feelers from high frequency indicators like steel consumption, capacity utilisation, balance sheets of banks and corporates, GST collections, E-Way bills, and infrastructure spending. The WTO has also hinted at improved prospects for world trade in this year.

With the FY24 GDP coming in at 8.2% and the incremental capital output ratio (ICOR) robust at 3.4X, an upgrade to the GDP growth was on the cards in June 2024. There were no such compelling reasons for an upgrade in August, so status quo in growth estimates was the answer. RBI has kept the GDP growth for FY25 static at 7.2%. On a quarter-wise basis, the GDP growth is projected at: Q1FY25 at 7.1%, Q2FY25 at 7.2%, Q3FY25 at 7.3%, and Q4FY25 at 7.2%. The FY25 GDP projection of 7.2% is subject to upward revision depending on data flows, but that would most likely happen after the Kharif data. Interestingly, the RBI has cut the Q1 GDP forecast by 20 bps, while keeping the other quarters constant.

KEY POLICY SHIFTS ANNOUNCED BY RBI, OUTSIDE MPC AMBIT

RBI monetary policy went beyond monetary numbers to signal a shift at a policy level. Here are some key announcements.

• To curb the instances of mis-selling and unscrupulous lending practices by digital lending apps, RBI is creating a repository of authorized digital lending apps (DLAs), so customers can verify their authenticity and credentials first.
• To improve the flow of credit information from the credit institutions to the credit information companies (CIC), the RBI has proposed to increase the frequency of reporting from monthly to fortnightly so the data is as current as possible.
• There are some interesting changes to the UPI system. The transaction limit for tax payments is being raised from ₹1 Lakh to ₹5 Lakhs per transaction. RBI also plans to initiate delegated UPI payment facility to expand the user base for UPI.
• In a major move, RBI plans to move the current cheque truncation system (CTS) from batch processing to continuous processing. This will reduce the cheque clearing time from T+1 day to just a few hours and make cheques a lot more efficient.

The August 2024 monetary policy had little by way of surprise. The two dissenting voices in the last two meetings will not be available from October 2024 MPC meet as they complete their 4-year term. For now, it looks like the RBI is waiting for cues from the US Federal Reserve, and how it tackles interest rates in the September Fed meeting.