Interest rate cut can be possible in Q1FY25 but that, too, would be data dependent

The RBI MPC (Monetary Policy Committee) maintained the repo rate at 6.5 percent at its meeting on August 10, in accordance with market expectations. Therefore, the standing deposit facility (SDF) rate will remain at 6.25 percent, the marginal standing facility (MSF) rate at 6.75 percent, and the Bank Rate at 6.75 percent. The Monetary Policy Committee (MPC) maintained its "removal of accommodation" stance with a 5:1 majority, as liquidity turned into a significant surplus and inflation rose. Given the recent rise in food prices and the steep increase in the RBI's inflation forecast, the hawkish pause was widely anticipated, with inflation taking centre stage and assuming a central role.

CPI inflation increased to 4.8% in June 2023 from 4.3% in May 2023, but remained within the RBI's acceptable range. The majority of the increase was attributable to a significant increase in food inflation, which rose to 4.6% from 3.3% a month earlier. Uneven monsoon and heatwave conditions have resulted in an abrupt increase in a few components of vegetable inflation. The sharp upward revision of near-term inflation projections (Q2FY24/Q3FY24 forecasts increased by 100bps/30bps to 6.2 percent/5.7 percent) is attributable to the food price risk. Although higher vegetable prices could pose an upward risk to CPI in the coming months, we believe this uptick is more transitory in nature and will subside in the second half of the fiscal year, per historical evidence. The RBI increased its CPI projection for FY24 from 5.1% to 5.4%.

After a delayed start, precipitation has increased; from a monsoon deficit in June to a 5 percent-above-average surplus in July. Recent IMD forecasts, however, indicate that August precipitation will be below normal (less than 94% of LPA). If the spatial distribution of rainfall remains asymmetrical, it could have a negative impact on kharif sowing and exacerbate food inflation in the future months. The recent increase in international crude oil prices as a result of supply decreases from OPEC+ countries could also increase imported inflation.

While food inflation is worrisome, the decline in WPI inflation is a source of solace. With a lag, the deflation of the WPI and the softening of the prices of many global commodities could provide some relief from the increasing inflationary pressures. Moreover, the moderation of core inflation provides additional solace. The core CPI fell to 5.1% in June of 23 and remains below the one-year average of 5.8%, reflecting the influence of past transmission on the real economy.

Studies have demonstrated that headline inflation follows the trend of core CPI, indicating that inflation dynamics are still under control. But the RBI is concerned about the impact on household inflationary expectations. In its statement, the MPC noted that these shocks are of a transient nature and can be disregarded for a period of time, unless there are repeated instances of food price shocks that pose a danger of anchoring inflation expectations. While the rainfall activity has acquired momentum, the temporal and spatial distribution of the same and a potential El Nio event would continue to be essential monitoring variables.

GST Collections, Corporate Tax Collections, and Income Tax Collections all indicate that India's economic activity has remained resilient. Urban demand continues to be robust, with domestic air passenger traffic and household credit maintaining double-digit growth rates. The recovery of kharif sowing and rural incomes, as well as the buoyancy of services and consumer optimism, should boost household consumption. While high-end consumption and government capital expenditures are thriving, domestic demand and exports remain subdued.

The government's emphasis on capital expenditure, higher capacity utilisation in the manufacturing sector, a moderation in commodity prices, and robust credit growth are growth stimulants. For FY24, the RBI has maintained its real GDP growth forecast at 6.5%. Significant hazards to GDP growth in FY24 include weaker global demand, geopolitical tensions, and the emergence of El Nino conditions.

Given the excess liquidity in the system, particularly as a result of the withdrawal of Rs 2000 notes, the RBI instructed scheduled banks to maintain an incremental CRR of 10 percent on the increase in their net demand and time liabilities (NDTL) between May 19, 2023 and July 28, 2023 in order to absorb the excess liquidity. As this announcement is negative for Banks in the short-term, the Bank Nifty fell following its release.

The impact of this announcement must be evaluated for each bank separately; the RBI will reconsider this decision by September 8 or earlier, based on the systemic liquidity levels preceding the holiday season. As the policy decision and commentary were essentially in line with expectations, the yield on India's 10-year government bonds remained rangebound.

RBI is expected to keep a close eye on the inflation outlook and is intent on maintaining inflation expectations firmly rooted at its primary target of 4 percent, despite the difficulty of the task.

We believe that the central bank appears to be less concerned with growth than it is with inflation forecast uncertainty. In light of the recent rise in food prices, the likelihood of a rate cut increases. We anticipate a rate reduction in the first quarter of fiscal year 25 (Q1FY25), pending data.

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