RBI holds repo rates at 6.5% in August, raises FY24 inflation forecast

10 Aug 2023 , 12:19 PM

Over the last 2 monetary policies, the RBI has been maintaining status quo on rates. The last hike of 25 bps was in February 2023. Between May 2022 and February 2023, the RBI hiked repo rates from 4.00% to 6.50%, a spike of 250 basis points in a span of 9 months. However, the RBI maintained status quo in April and June. In its latest policy announced on August 10, 2023, the RBI has once again opted to maintain status quo on rates. However, there have been some subtle shifts made. It has raised the inflation forecast by a full 30 bps to 5.4%, with most of the price pressure being imputed in the second quarter. The other big shift was absorption of liquidity through the imposition of 10% incremental CRR on deposits between May 19, 2023 and July 28, 2023. What is the logic behind these two shifts?

In the June policy, the RBI had cut its full year inflation forecast for FY24 by 10 bps from 5.2% to 5.1%. However, subsequent to that, the food inflation spiked due to delayed monsoons followed by a deluge in certain parts of India. Vegetables, pulses, and cereals have been the biggest casualties of erratic weather conditions. That explains why most of the spike in inflation estimates has been front-ended in the September quarter estimates with the inflation forecast being raised by 100 bps from 5.2% to 6.2% in Q2FY24.  The incremental CRR to absorb liquidity was to suck out the excess bank liquidity caused by the cancellation of the Rs2000 denomination notes. Here are the highlights of the policy.

Highlights of the RBI policy statement – August 2023

After the surprise of April, the status quo on rates in June was widely expected. But don’t miss the fine print, which we will deal with later.

• RBI maintained repo rates at 6.50% for the third policy in succession in August 2023 policy. Repo rates were already up 250 bps from the lows of May 2022 and a full 135 bps higher than the pre-COVID repo rate of 5.15%; despite the pause since April 2023. The vote for status quo on rates was unanimous.

   

• The RBI monetary stance continued to stay focused on withdrawal of accommodation; which was apparent considering the surplus liquidity in the system. The issue of liquidity has been exacerbated by the cancellation of Rs2,000 denomination notes. MPC members voted 5:1 in favour, with Jayanth Varma preferring a neutral stance.

   

• In order to absorb surplus liquidity in the system, the RBI increased the cash reserve ratio (CRR) for banks by imposing an incremental CRR for all net demand and time liabilities (NDTL) that came in between May 19, 2023 and July 28, 2023. This has been introduced as a temporary measure, but will be evaluated by next policy.

   

• Let us understand what status quo means for the linked rates. The SDF rate (erstwhile reverse repo) stayed pegged at 6.25%; pegged 25 basis points below the repo rate. Bank rate and marginal standing facility (MSF) rates stay pegged at 6.75%, pegged 25 bps above repo rates. 

   

• RBI held its GDP projection for FY24 at 6.5%, despite the better than expected GDP performance of 7.2% in FY23. RBI has expressed concerns of a perceptible in the global economy and expects that to rub off on the Indian growth engine. These effects are already visible in the size of merchandise and service exports in recent months.

   

• On the inflation front, the expected headline inflation for FY24 was raised by a hefty 30 bps from 5.1% to 5.4%. That is in the aftermath of the lag effect of food inflation as well as the downstream impact of Brent Crude prices spiking to above $86/bbl. RBI estimates have front ended most of the impact in Q2, with 100 bps rise in inflation forecast.

   

• The MPC did not give any hint on the terminal repo rates. However, there were enough indications that the MPC would not compromise on the 4% inflation target. That would mean handling the problem of inflation as well as liquidity, since both can trigger higher levels of inflation. For the RBI, it is not just about aligning inflation to the 4% levels, but also to anchor inflation expectations, which play a key role in determining prices.

In retrospect, the decision by the RBI to hold rates in April was bold, but it paid off as it put an immediate limit on the cost of funds and allowed corporates to show less pressure on their balance sheets. The GDP for FY23 has already been much better than expected and the RBI is only expected to play a catalytic role. However, one thing is clear from the language of the MPC and the statement of the RBI governor post the policy; rate cuts are some time off.

Global risks remain the big X-factor for the RBI

A quick reading of the RBI monetary policy statement underlines that global risks are the real worry for the RBI. In fact, there are several reasons. Firstly, crude prices have shot up to $86/bbl in the Brent market and the supply situation hints at further upsides. That is not only going to spiral the trade deficit but also a source of imported inflation. Secondly, while the US has shown some signs of recovery in GDP, the slew of downgrades of the US economy by Fitch and of US banks by Moody’s indicates that a slowdown is still possible. Europe and China are already giving hints of sub-par growth. That is likely to impact the demand for Indian goods and services and that is amply evident. The third risk is with reference to the differential rates. In the last two months, RBI has kept rates steady despite rise in inflation while the US Fed has hiked rates despite fall in inflation. This dichotomy is closing the real rate differential gap between India and US. Lastly, the downgrade of US debt by Fitch may not really impact the US dollar, but it is likely to favour risk-off flows over risk-on flows. That could have negative implications for emerging markets like India.

Inflation for FY24 hiked to 5.4%; GDP maintained at 6.5%

Inflation estimate for FY24 has been hiked by 30 bps from 5.1% to 5.4%. It had been lowered by 10 bps each in April and June 2023. The erratic monsoons (drought followed by deluge) have been very negative for food prices. A spike in prices of vegetables, pulses and cereals made the food basket more expensive. Rising crude prices is also likely to hit fuel inflation with its downstream impact on core inflation too. The RBI has decided to front end most of the impact in the second quarter to September 2023, where the inflation forecast has been raised by 100 bps from 5.2% to 6.2%. However, the RBI does expect the inflation to tone down after that once the Rabi stocks start coming into the market. The headline inflation has been pegged at 5.4% for FY24. In terms of next four quarters; the RBI has projected inflation Q2FY24 at 6.2%, Q3FY24 at 5.7%, Q4FY24 at 5.2% and Q1FY25 at 5.2%. Most of the inflation spike to its estimates has been front-ended in the September quarter.

However, RBI has retained its GDP growth estimate for FY24 at 6.5%, which is already higher than the World Bank estimates. As a result, the RBI has not hiked its estimates despite the World Bank and Fitch hiking the GDP estimates. The growth projections are largely predicated on a better than expected Rabi crop this season, which would give a big boost to rural incomes and rural consumption. Also, the latest quarter results for Q1FY24 show good traction on the top line. However, due to the fluid global situation, exports and global services are likely to remain under pressure. RBI has held its FY24 GDP forecast at 6.5% for the fiscal year. On a quarter-wise basis, the GDP growth is projected at: Q1FY24 at 8.0%, Q2FY24 at 6.5%, Q3FY24 at 6.0% and Q4FY24 at 5.7%. The RBI has also maintained all its quarter estimates intact. That explains the status quo in GDP projections for FY24.

Key policy shifts announced by RBI, outside MPC ambit

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

• Infrastructure development Funds (IDF) that provide refinance for the infrastructure sector, can now be floated without a sponsor. IDFs can be direct lenders to TOT projects and such IDFs can also raise funds via ECBs. 

   

• RBI has mandated greater transparency in interest rate reset for EMIs on floating rate loans. The communication of reset should include details of the reset, option to switch to fixed rate loan, foreclosure of loan and disclosure of conditions of excise of option.

   

• RBI proposes to enable conversational payments on UPI using AI powered systems. It will also allow the use of near field communications (NFC) for offline payments and also enhance the transaction limits for small value digital payments.

   

• RBI is testing frictionless end-to-end credit delivered digitally. It will have an open architecture and all financial sector players can connect seamlessly to the platform. It will be the equivalent of an agnostic ONDC platform in ecommerce.

April policy was a risk and June was a stop gap, but August policy is an affirmation that the RBI is willing to take the side of growth. Of course, global factors and domestic prices would still count, but the RBI may still prefer to wait for the lag effect of the rate hikes to feed into inflation. We will get a lot more clarity when the minutes of the MPC are published on August 24, 2023. The next policy statement on October 06, 2023 could be a lot more complex entailing some critical decisions for the RBI.