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

The RBI governor had concluded the policy meeting in June by saying, "The last leg of the journey is the toughest." The message was very clear: the RBI is no longer content with inflation between 2 and 6 percent on the headline CPI and is instead eyeing the 4 percent central line as a place to stabilise inflation. The southwest monsoon, international politics, deglobalization, an ageing global population, and other similar threats were all suggested.

A steep increase in the cost of staple foods like tomatoes, grains and pulses in July set the stage for the central bank to hike interest rates in August. The RBI is aware that these factors will cause the headline retail inflation rate to spike in the near future, thus they must be accounted for in the July inflation report.

There were no unexpected aspects of the policy, and the commentary was only somewhat hawkish, in contrast to market expectations. The RBI didn't buckle under pressure and kept rates and its position of eliminating accommodation unchanged (with one member voting against). The Reserve Bank of India (RBI) made it abundantly plain in its statements that the temporary rise in retail inflation induced by the seasonal increase in the costs of select vegetables would be disregarded for the time being. Naturally, this is based on the expectation (and historical precedent) that the price of vegetables will drop significantly in the coming months. For the time being, this strategy may be appropriate.

A new analysis by the RBI reveals that although the seasonal supply crisis has caused annual peaks in tomato prices to be higher than the previous year, the floor has been nearly strongly maintained. Consequently, there is a possibility of a precipitous drop in tomato prices as the kharif crop arrives (around mid-August).

The Reserve Bank of India (RBI) will need to keep a close watch on the trend of inflation going forward and be alert to the threats to price stability. After the war between Russia and Ukraine (the "Covid crisis"), supply shocks drove up prices. Changes in the climate, the amplified effects of El Nio this year, and the continued asymmetry in the distribution of India's southwest monsoons all threaten the stability of food prices.

Due to the difficulty in predicting the magnitude and duration of supply shocks, inflation forecasting has become a high-stakes endeavour. This brings the RBI's annual inflation projection up to 5.4% from 5.2%. The RBI increased its average inflation projection for Q2FY23 by 100 basis points (from an initial estimate of 5.2 percent in June to 6.2 percent today, due to the recent shock in vegetable prices). Additionally, the projections for Q3FY23 improve by 30 bps to 5.7%. Curiously, the projection for the fiscal year's last quarter is unchanged at 5.2 percent.

It's safe to assume that a forward-thinking central bank would factor inflation expectations into policy decisions. The RBI's inactivity was so comprehended. With an expected rate of inflation of 5.2% for the next calendar quarter (Q1FY23), a positive real interest rate of 130 basis points is implied by a currency policy rate of 6.5 percent. It's starting to make sense now.

Still, the RBI would "go beyond Arjuna's eye" and keep all possible instruments at the ready to bring inflation in line with the 4% target, thus the vigil on inflation will continue to take into account all relevant factors.

Inflation projections from YES Bank and the RBI are slightly different on a quarterly basis but remain very close on an annual one. No further rate hikes by the RBI are expected if inflation trends continue along these lines for the remainder of the year.

The possibility of a reduction in the policy repo rate by the RBI in FY24 has been the subject of recent speculation. As a result of the unexpected spike in prices, a reduction in interest rates is now unlikely before FY25. It is becoming clear that the US economy has shown surprising resilience to the huge and fast dose of interest rate rises in that country, effectively delaying the date of any Fed rate cut.

The RBI maintained the status quo on policy rates but warned of threats to price stability from an abundance of liquidity. The RBI's attempts to sustainably drain out the surplus liquidity via the 14-day VRRR (variable rate reverse repo) have been hampered by the market's lack of enthusiasm for this instrument. The Reserve Bank of India has mandated that, from May 19th to July 28th, banks keep a 10% CRR on their NDTL balances.

Based on our estimates, the banking system could feel a burden of almost Rs 1.1 trillion. The planned date for the measure's repeal is September 8; this will prevent a sudden drying up of banking sector liquidity in preparation for the holiday season's expected rise in C.I.C. The marginal cost of funds for the banking system will rise as a result of this action, but as the increase is expected to be short-lived, the banks may be ready to bear the cost themselves rather than pass it on to their consumers.

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