What to expect from August 2024 RBI Monetary Policy?

6 Aug 2024 , 02:00 PM

MONETARY POLICY EXPECTATIONS – BUDGET 2024-25 TRIGGER

In the previous monetary policy in early June, the context was the election outcome. At that point, the results were out but the jury was still out in the open about how the government would be formed. The ruling BJP had fallen about 30 seats short of the half-way mark, which meant they would have to rely on the coalition partners like Nitish Kumar and Chandrababu Naidu to form the government. Thanks to the pragmatism shown by the prime minister, the government formation was a smooth affair. However, the big even in the intervening period was the full budget announcement. The budget was mixed on the macros front, but there were several measures that were patently negative for the capital markets as a whole.

On the positive side, the government reduced the fiscal deficit target for FY25 by another 20 bps to 4.9% of GDP. It may be recollected that in the previous budget in February 2024, the fiscal deficit for FY24 had been set at 5.9% of GDP. In the interim budget in February 2025, the fiscal deficit target for FY24 was reduced to 5.8% of GDP, while the fiscal deficit target for FY25 was set at 5.1%. When the final fiscal deficit number for FY24 was announced in late June 2024, it came in lower at 5.6% of GDP. As a result, in the full budget announced on July 23, 2024, the fiscal deficit for FY25 was further reduced to 4.9% of GDP, thanks to the ₹2.11 Trillion dividend paid by the RBI to the government. Economists were concerned about the larger outlays to Bihar and AP as well the higher food subsidy bill. However, the 4.9% fiscal deficit target for FY25 is testimony that fiscal prudence will be the focus. Overall, the budget was conducive for the eventual reduction in repo rates, amidst fiscal prudence.

MONETARY POLICY EXPECTATIONS – US RECESSION TRIGGER

The big development in the last few days has been that the US Recession is increasingly being touted as a distinct possibility. Of course, the data points are still quite limited. The rate of unemployment in the US in July 2024 went up to a 34-month high of 4.3%. The last time the US saw higher unemployment was in October 2021, when inflation was starting to raise its head and rate hikes were yet to start. In the last one year, the rate of unemployment has gone up from under 3.5% to the current level of 4.3%. Additionally, the inverted yield curve (higher yields in 2-year bonds than in 10-year bonds) is also indicating at a likely recession. How would that impact the RBI policy statement on August 08, 2024. The question is whether the RBI MPC would really be able to act on the US Recession trigger?

To be fair, the RBI MPC may be constrained for time. The US recession debate has just picked up momentum in the last 3-4 days and that is when the markets have also started crashing. However, at the back of the mind, the MPC members will surely have this as a context. Why is the US Recession argument important for RBI monetary policy? Firstly, if the Fed gets aggressive on rate cuts (as the CME Fedwatch is expecting), then the RBI may not want to be left behind. While the US recession argument may not impact the rate decision or the stance of the monetary policy, the RBI MPC will try and build in some buffers in its language. That would pacify the analysts and the traders that in the event of any macroeconomic emergency, the RBI would be ready and willing to act at short notice.

HOW MACROS SHAPED UP SINCE THE JUN-24 MONETARY POLICY?

Since the June 2024 policy, the big news was the general elections outcome. However, there were other important macro data updates too.

1. The big data point was the current account deficit (CAD) for the full year FY24, which was announced towards the end of June 2024. The CAD updated was a lot more flattering than expected. For instance, the Indian economy bounced into a current account surplus in the fourth quarter of FY24 to the tune of 0.6% of GDP. As a result, the full year current account deficit stood at just about 0.7% of the GDP. This is not only positive for the Indian rupee, but also for the way the rating agencies would look at the Indian economy. While rating upgrades may still be some time away, the outlook is likely to be increasingly positive as far as rating agencies are concerned.
2. The second big data point was the full budget announced on July 23, 2024. The full year fiscal deficit for FY25 was further cut from 5.1% to 4.9%. While, the total infrastructure outlay was held at the interim budget level of ₹11.11 Trillion, the good news is that the RBI dividend largesse of ₹2.11 Trillion has been put to good use. Even after taking care of the enhanced food subsidy bill and the higher allocations to the states of Andhra Pradesh and Bihar, the government could still reduce the fiscal deficit by 20 bps as a share of GDP. That promises stable to benign bond yields in the Indian economy.
3. Of course, no discussion on key macros is complete without discussion on consumer inflation. The India inflation has been around the 5% mark and in June, the consumer inflation came in higher at 5.08%. The delayed monsoons had an impact on the food prices and it is food inflation that not threatens to get into double digits for the food basket as a whole. While the delayed rains have restored a sense of normalcy, the concern is that the late deluge may actually lead to excess crop spoilage. In fact, some of the key Kharif producing states like Punjab, Haryana, Bihar, and Jharkhand continue to be rain deficit states. The impact on food output may still be quite high.
4. While the first quarter GDP number will be out on the last working day of August 2024, a good proxy is visible in the core sector numbers. The core sector growth has faltered in the latest month of June 2024 to just 3.95%. The pressure has come from oil extraction and refinery products, with the latter being extremely significant due to its 28.04% weight in the core sector basket. More importantly, the tapering core sector growth shows the impact of lower infrastructure outlay and the election related slowdown. If it is just an election driven slowdown, there is not much to worry about. However, if the lower growth in infrastructure outlay is impacting core sector growth, then that is something the government may have to do a rethink on!

In the last few days, the US recession fears have led the oil prices sharply lower with the Brent crude price almost at $76/bbl. The big story to watch out for between now and the September policy statement by the US Federal Reserve, is the language on rate trajectory. The US thinking on rates is likely to have a profound impact on how the RBI would also like to guide the interest rate trajectory in India.

WILL THE RBI ATTEMPT RATE CUTS IN AUGUST 2024

RBI has kept the repo rates at the current level of 6.5% since February 2023. Effectively, the August 2024 monetary policy could be the ninth policy in succession when the RBI is unlikely to tamper with rates. The reasons are not far to seek. The GDP growth is still robust and the inflation remains above 5%. That is more than 100 bps away from the RBI target of 4%. However, due to the US recession fears, the RBI MPC may fashion its statement on the trajectory of rates a little more carefully.

The RBI MPC has not had much time to react to the US recession debate or to the rapidly changing undertone of the CME Fedwatch. Obviously, the RBI MPC would be tracking both these variables as they have long term repercussions for India’s rate stance. While the RBI may abstain from rate cuts in the August policy, it is likely to underline that the central bank remains prepared to tweak interest rates at short notice to support growth. A US recession is likely to have its repercussions on India and the RBI must have a Plan-B in place.

COULD THE RBI CHANGE THE MONETARY STANCE TO NEUTRAL?

If you look at the June RBI MPC minutes, there was a subtle shift. Two members of the MPC, viz., Jayanth Varma and Ashima Goyal had voted in favour of cutting rates by 25 bps and also shifting the stance of the monetary policy to “Neutral.” Jayanth Varma has persistently opposed static rates and holding status quo on monetary policy. According to Varma, the situation is ripe for a 25 bps rate cut and changing the stance of the monetary policy. In the words of Jayanth Varma, the current stance at “gradual withdrawal of accommodation” is out of sync with the market liquidity reality. While one cannot be too sure, there is an outside possibility that the RBI MPC may shift the stance of the policy to “Neutral.”

That is something Varma and Goyal had extensively argued in the MPC minutes of June 2024. The gradual withdrawal of accommodation is hardly relevant at a time when the US appears to be on the throes of a recession and the central bank policy response may have to be once again about easing liquidity. More importantly, changing the stance of the monetary policy to neutral, offers the perfect backdrop for the Monetary Policy Committed to take up rate cuts in the October 2024 policy. A change in stance may sound far-fetched at this juncture, but if RBI has rate cuts in mind, then the time to shift the stance is now.

WORD OF CAUTION – RBI MPC COULD RAISE INFLATION ESTIMATES

The FY25 inflation target was pegged at 4.5%, a good 90 bps below the FY24 inflation level of 5.4%. That means, the RBI has already pegged a sharp fall in inflation in FY25. The early indications that we are getting from food inflation and headline inflation is that the average inflation in the first half of FY25 could be higher than that. Also, the delayed rains could have a lag effect on crops and also on reservoir levels. Overall, the narrative could be that food inflation and headline inflation could remain at elevated levels for much longer. This is despite the fact that crude oil prices have fallen from $90/bbl to $76/bbl in the crude market. While oil has its externalities, it is food that is the swing factor in India inflation.

In our June expectations, we had hinted at the possibility of coalition politics imposing a higher than expected cost on the exchequer. That is happening and we have already seen that in the budget number. Also, if Russia also cuts its supply and China shows a recovery, then we could see a sharp spike in oil prices in the second half of fiscal FY25. That would mean imported inflation hitting the Indian economy. Also, a recovery in China could fuel inflation across metals, alloys, and minerals. Whether the RBI raises the inflation estimates for FY25 in the August policy or in the October policy, is an academic argument. However, the truth is that there is a strong case for a 20-30 bps hike in inflation estimates for FY25.

FY25 GDP UPGRADE IS UNLIKELY FOR NOW

In the June policy, the RBI had raised the GDP growth estimates for FY25 by 20 bps from 7.0% to 7.2%. That was much lower than the 50 bps that the street was expecting. However, that looks like a good decision in retrospect, especially with the US economy now on the throes of a possible recession. Also, if the US slips into recession, then the impact on India trade, Indian merchandise exports and the services sector could be huge. That could knock off a few bps from the GDP growth. For now, the RBI is unlikely to tamper with the GDP growth estimates for FY24 and retain it at 7.2%, the level it had set in the June policy. However, any GDP upgrades look unlikely for the time being.

FORGET RATE GUIDANCE, FOCUS ON THE US ECONOMY

Behind the scenes, the one thing that the RBI MPC would be frantically doing is to track the news flows on the US economy. Unemployment has risen sharply to 4.3% and the yield curve has inverted after a gap of nearly 2 years. Both are indicative of a likely slowdown in the economy. However, as we have seen in the past, it is not a recession till the NBER says so. That did not happen in 2022, despite 2 quarters of negative GDP growth, and we could see such a reluctance this time also. Frankly, it would be premature to expect rate guidance from the RBI MPC. Clearly, one has to closely track what happens in the US in the next few weeks. That could hold the key to what the RBI will do between now and October!