Recent inflation surprise pushes out expectation for rate cut into FY25: Indranil Pan

Recent inflation surprise pushes out expectation for rate cut into FY25: Indranil Pan

“The last leg of the journey is the toughest,” commented the RBI governor as a concluding statement during the June policy meeting. This statement conveyed a clear message that the Reserve Bank of India (RBI) is no longer content with merely maintaining the headline Consumer Price Index (CPI) inflation within the 2-6 percent band.

Instead, the RBI is actively focused on anchoring inflation closer to the central line of 4 percent. The central bank also highlighted various risks, including factors such as the southwest monsoon, geopolitical tensions, deglobalization trends, and the aging global population.

The context leading up to the August monetary policy was that inflation had been relatively well controlled up to the June data. However, July witnessed a significant and sudden surge in the prices of essential commodities such as tomatoes, cereals, and pulses. These sharp price increases are expected to contribute to a notable rise in the headline retail inflation for the near term.

This situation presents a complex challenge for the RBI as it aims to balance its objectives of managing inflation and supporting economic growth. The central bank’s acknowledgment of these inflationary pressures and its commitment to steering inflation closer to the 4 percent target underscores its proactive approach in responding to changing economic dynamics. The RBI’s strategy reflects its dedication to maintaining price stability and ensuring a conducive environment for sustainable economic development.

The recent monetary policy announcement by the RBI unfolded without any unexpected elements. Contrary to market expectations, the central bank’s communication carried only a subtle and cautious leaning toward a more hawkish stance. Opting for a composed approach, the RBI opted to maintain the status quo on both interest rates and policy stance (although a single member dissented by voting for the removal of accommodation).

In terms of its communication, the RBI was unequivocal in its stance to overlook the current temporary surges in retail inflation, attributed to the seasonal upswing in certain vegetable prices. The central bank seems to be prioritizing a forward-looking perspective, anticipating a substantial correction in vegetable prices over the coming months, as evidenced by historical trends.

An RBI study highlights a consistent pattern where tomato prices have experienced annual peaks that are higher than the preceding year, while the lower price thresholds have remained relatively resilient. This dynamic suggests that the impending kharif crop arrival, expected around mid-August, may trigger a sharp downturn in tomato prices, aligning with historical trends.

The RBI’s approach to disregard transient inflationary pressures, particularly those arising from seasonal vegetable price fluctuations, seems prudent. By considering historical patterns and potential future corrections, the central bank aims to avoid overreacting to short-term variations that might naturally resolve themselves. This approach underscores the RBI’s commitment to maintaining a balanced and pragmatic monetary policy, supporting price stability while fostering an environment conducive to sustainable economic growth.

Looking ahead, the Reserve Bank of India (RBI) will maintain a vigilant approach in monitoring the trajectory of inflation and will remain attuned to potential risks to price stability. Recent global events, such as the ongoing Covid-19 crisis and the Russia-Ukraine conflict, have induced supply shocks that triggered inflationary surges. Moreover, climate changes, the heightened El-Nino phenomenon this year, and the uneven distribution of southwest monsoons in India collectively contribute to the risk of instability in food prices.

In the current landscape, predicting inflation has become inherently uncertain due to the complex interplay of various factors and the challenges in gauging the severity and duration of supply shocks. Reflecting this, the RBI has revised its inflation forecast upwards by 30 basis points to 5.4 percent for the year.

The recent shock in vegetable prices has prompted the RBI to revise its forecasts for specific quarters. The average inflation projection for Q2FY23 has been elevated by 100 basis points to 6.2 percent, compared to the 5.2 percent estimate made in June. Similarly, the inflation forecast for Q3FY23 has been adjusted upwards by 30 basis points to 5.7 percent. Notably, the Q4FY23 forecast remains unchanged at 5.2 percent.

These revisions in inflation projections highlight the central bank’s dynamic response to emerging developments and its willingness to recalibrate forecasts based on real-time data and evolving trends. The RBI’s cautious approach underscores its commitment to maintaining price stability while remaining adaptable in a complex and unpredictable economic environment.

A forward-looking central bank, such as the RBI, naturally takes into account the projected trajectory of inflation when making its monetary policy decisions. This rationale explains why the RBI opted to maintain its pause mode in its recent policy announcement. With inflation expectations for the upcoming year, specifically Q1FY23, set at 5.2 percent, the current policy rate of 6.5 percent results in a positive real interest rate of 130 basis points. This alignment between policy rate and projected inflation signifies a reasonable approach at this juncture.

However, this doesn’t mean that the RBI’s attention to inflation will waver. The central bank will persist in vigilantly monitoring all elements influencing inflation, ensuring that all the variables are considered comprehensively. The RBI is fully prepared to use all the tools at its disposal to steer inflation toward its target of 4 percent. This unwavering commitment to achieving and maintaining price stability is reflected in the central bank’s willingness to be proactive and deploy necessary measures as required.

The reference to “going beyond Arjuna’s eye” metaphorically illustrates the RBI’s determination to be astute and far-sighted, using a comprehensive approach to ensure that inflation remains under control. The central bank’s readiness to deploy appropriate instruments underscores its dynamic and responsive stance in the face of evolving economic conditions.

YES Bank’s own inflation model diverges slightly from that of the RBI when it comes to quarterly forecasts, but the average forecast for the year remains quite closely aligned. Based on the current trajectory of inflation, if it continues along these lines for the rest of the year, there might not be any further rate hikes by the RBI.

Earlier, there were discussions about whether the RBI would lower the policy repo rate in FY24. However, the recent surprise in inflation has pushed back any expectations of a rate cut to FY25. Additionally, the evolving narrative of the US economy displaying unexpected resilience to significant interest rate hikes has led to a postponement in expectations for any rate cuts by the US Federal Reserve.

While policy rates have remained unchanged, the RBI has expressed concerns about excessive liquidity posing risks to price stability. The market has not responded favorably to the 14-day Variable Rate Reverse Repo (VRRR), limiting the RBI’s efforts to manage excess liquidity in a sustained manner. To address this, the RBI has instructed banks to maintain an incremental Cash Reserve Ratio (CRR) of 10 percent on Net Demand and Time Liabilities (NDTL) balances between May 19 and July 28. This move is estimated to drain around Rs 1.1 trillion from the banking sector. The tentative withdrawal date for this measure is September 8th, ensuring that banking liquidity doesn’t overly tighten, particularly with the expected increase in Currency in Circulation during the festive season.

While this measure might slightly increase the cost of funds for the banking system, it is temporary in nature. Banks are likely to absorb this cost without necessarily passing it on to customers, understanding that it is a short-term strategy to manage liquidity and stabilize the banking sector.