Maintaining status quo in the credit policy is significant for several reasons. To begin with, the policy announcement in June did flag that there were limits to which the repo rate could be lowered in order to increase growth. This sent a strong message to the market: rates cannot be lowered just because inflation was coming down. While growth can be revived, there are limits to that. In a way, the change of stance from accommodative to neutral after lowering the repo rate aggressively by 50 basis points (bps) signalled a new wave of thinking in the Monetary Policy Committee (MPC). This was based on the principle of front-loading which would then be given time to work through the system. To complement this approach, the cash reserve ratio was also lowered by 100 bps, albeit from September onwards. It was hence a comprehensive package.
The current policy of status quo sends some messages too. The first is, India’s growth story is still strong at 6.5%. More importantly, the adjustments to forecasts were not really required in the absence of any new information. This means the tariff impact was already factored in June as the US made the announcement in April. Although deferred till August, the tariff of 25% was not different from what was announced earlier. (That, however, got revised with an additional 25% tariff declared by the US on Wednesday). And surely, the Reserve Bank of India (RBI) had indicated that when there is new information on tariffs, revisions could always be made.
The other takeaway is on inflation. The RBI has dropped its inflation forecast to 3.1% from 3.7%. This is quite sharp based on the trajectory of food prices. Hence the forecasts for Q3 are also low at 2.1%. But then, it has been pointed out that inflation will rise to 4.4% in Q4 and 4.9% in Q1 FY27. This is of importance because any change in policy rate, when linked with inflation, has to look at the scenario in future. This is why monetary policy is always said to be forward-looking. This means that if inflation is 2.1% in Q2, with a repo rate of 5.5%, the real repo rate would be 3.4%. However, once we move to Q4, the real rate would be 1.1% and further 0.6% in Q1 FY27. In such a scenario, should the central bank be increasing rates?
Therefore, maintaining status quo can be justified even on the grounds of inflation being low today. Here the policy says more about why inflation is low. It is a pure case of statistical base effects, which means if inflation was high last year then the inflation rate will tend to get depressed this year. The same logic will take it to 4.9% in Q1 FY27 although there may not be any distortion in commodity prices.
Further, the low prices today are mainly on account of prices of food, especially vegetables. Food prices tend to be volatile and they can rise any time when crop supplies falter. Therefore, one should not get carried away by low inflation as a result of falling food prices.
Also, non-fuel non-food inflation numbers have tended to rise and are over 4%. This core inflation will be sticky for some more time as companies are increasing their prices to cover higher costs. This has been seen in education and health, where charges have been increased across the board.
Similarly for consumer products and household goods, there has been a tendency for companies to hold on to costs for an extended period as demand was sluggish. In the last year or so, they have been increasing prices to cover the costs. Thus, in both manufacturing and services there has been a series of increases in prices that had added to core inflation.
The RBI has also cleared the air on liquidity issues, specifying that the current liquidity framework is good enough where the weighted average call rate would be targeted and support provided through variable rate repo and reverse repo auctions.
Here too, the RBI was expected to revise the framework as the tri-party repo market had become more popular. But the committee instituted to analyse it has concluded that the present policy is adequate and there was no need to change the target for now.
So how can one look ahead? Will there be any further rate cuts? Given the present dynamics of inflation and growth, it looks like that if the RBI forecasts hold, there would be no need to tinker with the repo rate for the rest of the year and the terminal rate can be 5.5%. The only trigger can be if growth falters sharply. This is a tough call as it does not look like growth could slip by another 0.1-0.2% in case the tariff issue turns nasty.
As long as growth is in the 6.2-6.5% range, the growth story is unlikely to be seen as under threat. Lower inflation for the year may not matter as of now as what is critical on the price front is the Q4 outlook. This should not change as the future assumptions are unlikely to get altered. Under these circumstances, the most optimistic scenario for industry could be not more than one 25-bps cut possibly in December depending on the prevailing environment.
But the market will look for external signals, which can be the Fed cutting rates, to have a bearing on RBI decisions. The Federal Reserve has been quite recalcitrant to lower rates in the tariff quagmire. But assuming it does from December onwards, the movement in foreign investment funds as well as the currency could be another justification for the RBI to lower rates. While this may not be on the MPC’s radar, the market will use it as an anvil to ask for more.
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