RBI holds repo rates at 6.5%; cuts policy stance to neutral

9 Oct 2024 , 01:22 PM

WHAT HAS CHANGED SINCE THE AUGUST 2024 MONETARY POLICY

In the last 2 months since the August 2024 policy was presented by the RBI Monetary Policy Committee (MPC); a lot has changed apart from half of the MPC members. Let us talk about the MPC composition first. The August 2024 policy marked the end of the tenure of 3 noted economists in the MPC. These included Shashank Bhide of NCAER, Ashima Goyal of IGIDR, and Jayanth Varma of IIM-Ahmedabad. Three new members have been inducted into the MPC in their place. These include Prof Ram Singh, Director, Delhi School of Economics; Dr Saugata Bhattacharya, former chief economist at Axis Bank; and Dr Nagesh Kumar, Director, and CEO of the Institute for Studies on Industries Development (ISID). The other 3 members representing the RBI remain the same (including the RBI governor). But a lot more has changed in the intervening period between August policy and the October policy.

Firstly, the first quarter GDP growth for FY25 came in lower than expected at 6.7%. However, the fall in real GDP growth was more an outcome of higher inflation because the nominal GDP was actually higher on yoy basis and also on sequential basis. Secondly, the current account deficit CAD) for Q1FY25 at 1.1% of GDP was higher than expected due to the impact of higher merchandise trade deficit and services surplus struggling to grow. Thirdly, in an important shift, the US Fed cut rates by an aggressive 50 bps and admitted that the special effort was to quickly bring down the unemployment from an elevated level of 4.3% in August. Lastly, the big development has been on the geopolitical front which has gone from bad to worse in the last 2 weeks with Iran and Israel on the edge of a full-fledged war. That has the potential to disrupt key trade routes and spike oil and commodity prices.

NEUTRAL STANCE IS MORE OF A TEMPORARY MIDDLE PATH

Ahead of the policy announcement, there was a big debate as to what the RBI MPC would do in its policy statement. In our pre-policy note we had underlined that rate cuts were unlikely since the geopolitical risks in West Asia had huge inflationary potential and the RBI would not want to risk rate cuts at such a juncture. However, we had also suggested that (like the Fed), the RBI would cut rates first and then worry about changing the stance of the monetary policy. However, the RBI today went ahead and changed the stance of the policy to “Neutral” while maintaining the rates at 6.5%. How to interpret this decision?

It is tough to say, but there are 3 possible reasons why the RBI opted to change the stance of the monetary policy to “Neutral”, while holding the repo rates at 6.5%. Firstly, the RBI is trying to give out a signal that it proposes to cut rates in the coming policy in December or latest in February 2025. This change in stance can be seen as a precursor to a rate cut. Secondly, this move is acknowledgement of the fact that the situation in India is different. Here, the oil vulnerability is high and the risk of imported inflation is also very high. Hence, it would be a good idea to absorb the full impact of the West Asian crisis, before taking a call on the rates. Thirdly, this is also an indication that the monetary stance of “gradual withdrawal of accommodation” was out of sync with the liquidity situation in India and hence, the shift to a Neutral stance was more academic.

HIGHLIGHTS OF THE RBI POLICY STATEMENT – OCTOBER 2024

The RBI maintained status quo on rates for the 10th successive MPC meet. However, status quo was across other data points too. The only change was in shifting the stance of the policy to Neutral. Here are key takeaways from the MPC statement.

• RBI held repo rates at 6.50% for the tenth policy in succession. The last time the repo rates were hiked was in February 2023. It must be noted that the repo rates are currently 135 bps above the pre-pandemic level of 5.15%. At the same time, real rates are around 1.8% to 2.0%; which is higher than the median. Interestingly, despite a new look MPC committee, one of the recent inductees into the MPC (Dr Nagesh Kumar) did not concur with the MPC and voted for cutting repo rates by 25 bps. However, the decision to change the stance of the policy to “Neutral” was unanimous.
• System liquidity remained in surplus during August-September and also in the first week of October 2024. This was largely on account of pick-up in government spending and a fall in currency in circulation. The liquidity had slipped into deficit in the second half of September due to advance tax collections, but that had been adjusted by the RBI through two-way operations. The term premiums and the yield spreads between the long term and short term bonds have also been stable in recent months0.
• 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). There is no change here.
• The last GDP estimate shift was in the June policy statement, wherein the RBI had upgraded the GDP growth estimate for FY25 by 20 bps from 7.0% to 7.2%. In August 2024, there was no change in the GDP growth estimates despite the healthy ICOR (incremental capital output ratio). In a sense, the RBI was right in erring on the side of caution as the spike in geopolitical uncertainty in West Asia and the higher than expected current account deficit do put some limits on growth. Also, the indications are that high interest rates are keeping corporate results also under pressure in the second quarter. Not surprisingly, the RBI MPC did not make any changes to its growth estimates for FY25 and retained GDP growth forecast at 7.2%.
• What about inflation forecast? The forecast for FY25 stand at 4.5%. That already means, the RBI expects upsides to inflation in the second half of FY25, since the average inflation in the last two months has been well under 4% target. There were expectations in August that the RBI may raise the inflation target for FY25 by 25 bps to 4.75%, but that was not the case. In the October 2024 policy, the RBI has again kept its inflation forecast for FY25 static at 4.5%, despite the risks of imported inflation due to the West Asian crisis and possible impact on oil prices. The RBI, apparently, believes that the 3.6% average inflation in the previous two months would be sufficient to guide the full year inflation to 4.5%, even assuming some spill-off effects of the West Asian crisis.
• The RBI continues to remain non-committal about the timing and quantum of rate cuts in the coming months. RBI may not be in a position to offer a longer term perspective like the Fed does since the RBI has to deal with a number of X-factors ranging from erratic monsoons to oil imports to food prices. One perspective is that the RBI would not venture to cut rates 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, a counter argument could be that the RBI has already changed the stance to neutral and so rate cuts should logically follow in the next two policies. We have to wait and watch. The real story, however, could be in the GDP growth, which continue to be robust at a nominal level. Status quo on rates may continue for a few months more; purely because the RBI can afford to keep its options open. The Fed has set the ball rolling on rates, but apparently, the RBI still wants to chart its own course on rates.

Let us now turn to the nuances of inflation and growth in the October 2024 policy.

RBI HOLDS INFLATION PEG FOR FY25 AT 4.5%

Headline inflation had moderated to 3.6% in July and August, which is below the RBI target of 4%. However, September inflation is likely to spike due to the base effect. Also, the RBI is not too sure how the crisis in West Asia will eventually impact oil prices in India. After all, if Israel starts bombing the oil installations of the National Iranian Oil Company (NIOC) and if Iran blockades the Straits of Hormuz, then oil could become much dearer at short notice. However, there have been several positives for inflation. The pick-up in kharif sowing, robust foodgrain buffer stocks and easing global food prices are positives for prices. The IMD has given its final estimate for monsoons at 107% of the long period average (LPA), which implies a robust Kharif crop this year. Two things that may be worrying the RBI are energy inflation and core inflation. The former could get badly hit by the crisis in West Asia and the problem is that oil also has strong externalities. A sharp spike in inflation has secondary effects on food inflation and core inflation too.

There are several headwinds to inflation. Geopolitical tensions are running high, Iran / Israel are on the brink of war, and global commodity prices are volatile. Also, we only have data for Kharif and the Rabi may still be subject to weather conditions and the level of reservoirs. Core inflation has been rising in India as the biggest gains of supply chain normalization appear to be done and dusted. 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 4.1%, Q3FY25 at 4.8%, Q4FY25 at 4.2%, and Q1FY26 at 4.3%. In short, the RBI does not see any major impact on inflation from the West Asia crisis.

RBI HOLDS GDP GROWTH ESTIMATE AT 7.2% FOR FY25

With Q1FY25 GDP growth lower than expected at 6.7%, the October policy was not going to tinker with the growth rate. The RBI would take solace from the fact that the lower real GDP growth in Q1FY25 was largely on account of higher inflation since nominal growth rate was higher on a yoy basis and also on a sequential basis. That means, economic activity was still robust and the best the RBI could do was to not let inflation spiral out of control. Like in the August policy statement, even the October 2024 statement has maintained the GDP growth estimate for FY25 at 7.2%.

The 107% of LPA monsoons and healthy kharif 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 were deeply rainfall deficit. In August 2024, core sector contracted by -1.77%. This could be an outcome of lower capex growth, but it raises questions over sustaining high GDP growth if the basic infrastructure sectors are under pressure. This was the first core sector contraction in 42 months and if you just consider normal times, this was the first core sector contraction since April 2015. Growth estimates could be at risk, if the capex support does not come through.

In the August policy there was no justification for an upgrade to GDP estimates and the same story holds in October too. More so, with the crisis in West Asia and likely disruption of prominent trade routes, some impact on trade and GDP is bound to be there. Hence, status quo in growth estimates was the safest option. RBI has kept the GDP growth for FY25 static at 7.2%. On a quarter-wise basis, the GDP growth is projected at: Q2FY25 at 7.0%, Q3FY25 at 7.4%, Q4FY25 at 7.4%, and Q1FY26 at 7.3%. The FY25 GDP projection of 7.2% is still quite vulnerable to the crisis in West Asia. However, the RBI has been quite positive about the GDP growth in the third and fourth quarter of FY25.

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 encourage responsible lending, RBI has proposed to extend the zero-foreclosure rule for floating rate loans to MSMEs also. Currently, this rule is applicable for individuals on all floating rate loans taken, except for business loans.
• In a bid to regulate climate risks to the financial system, the RBI has proposed to create a data repository on local climate scenarios, climate forecasts, and emissions. The climate information system will have a web-based interface and also raw historical data.
• RBI has also proposed to expand the limits of UPI Lite and UPI 123-Pay. In the case of UPI 123-Pay, the per transaction limit has been raised from ₹5,000 to ₹10,000. In the case of UPI Lite , the transaction limit has been raised from ₹500 to ₹1,000; while the UPI Lite Wallet limit has been raised from ₹2,000 to ₹5,000.
• RBI also plans to launch the beneficiary look-up facility in NEFT and RTGS transfers, just like in the case of UPI transactions. Even in NEFT and RTGS transactions, the transferor will be able to verify details of transferee, to reduce risks of wrong transfers.

The October 2024 monetary policy held repo rates at 6.5%, although it was surprising they opted to change the stance of the monetary policy from “gradual withdrawal of accommodation” to “Neutral”. Interestingly, there was one dissenting voice with Dr Nagesh Kumar voting for a 25 bps rate cut. That rate cut should be coming; either in December 2024 or in February 2025!