Monetary Policy Preview: A Move Towards An Eventual Rate Cut Complicated By Global Vulnerability

We expect a continuing split 4-2 vote for holding the policy repo rate at 6.5 per cent (held since February 2023) and on retaining the stance of “remaining focused on withdrawal of accommodation” (although this will be a close call.

The language is likely to be dovish, giving a signal that the MPC might be on the verge of preparing for a path to an eventual rate cut. 

What Factors Might Result In This Policy outcome?

Nothing significant has changed in India’s domestic economic conditions and outlook since the last policy review in early June.

However, the global environment, particularly in the US, has undergone a profound shift. Post the release of the Non Farm Payrolls (NFP), the closely watched indicator of jobs in the US, fears of a recession have again come strongly out front.

The NFP release showed that only 114,000 new jobs had been created in July, much lower than analysts’ expectations of 176,000 and the 179,000 jobs created in June.

Even more concerning for the markets was a further rise in the Unemployment Rate (UR) to 4.3%, sharply higher than the 4.1% recorded in June. Note that earlier Fed economists had forecast a 4.3% UR at end-2025. 

The so-called “Sahm Rule”, which had receded over the past 6 months or so, with expectations of the US Federal Reserve (Fed) engineering a “soft landing” for the US economy, has now once again become very visible.

This Rule indicates a recession starts when the 3-month moving average of the UR over the past 3 months is 0.5 percentage points or more higher than the lowest point in the previous year.

Although a recession still appears unlikely, markets are now fully expecting at least a 0.25 percentage point cut in the Fed’s policy rate at its mid-September meet.Some expect an unusual 0.5 percentage point cut.

Economic Dynamics Are Still Pointing To A Sharp Slowdown 

At the same time, the two other large economies, the European Union (EU) and China, are also experiencing a deepening slowdown. EU’s largest economy, Germany, in particularly is in the midst of a prolonged slowdown, exacerbated by its trade links with a faltering Chinese domestic consumer demand. 

The essential dilemma of global central banks has now become when to cut their policy rates and avoid the mistake of holding policy tight for too long and tipping their respective economies into a recession.

This is particularly problematic for the Fed, given their dual mandate of managing inflation while promoting maximum employment. (The other large central banks are focused on an inflation target). 

How Will This Affect India’s Economic Outlook?

India’s growth story still remains strong, although there are signs that the momentum is slowing. The RBI had, in June, revised up India’s FY25 GDP growth to 7.2% (from its earlier 7.0%). This was before the global problems had begun to intensify.

The Economic Survey, in mid July, had been more cautious, predicting growth between 6.5-7%. Various high frequency indicators are also showing signs of a slowdown.

Economic activity indicated by both the manufacturing and services Purchasing Managers Indexes (PMIs) is slowing even though the PMIs still remain at strongly expansionary levels. Financial results of listed companies show net sales and profits growth also moderating. 

In addition, the global slowdown and turmoil in financial markets will exact a further toll on India’s economy. The primary channel will be trade. Merchandise exports had slowed sharply in FY24, to an average of less than 1% (year on year).

Services exports, which had been very robust in FY23 and FY24, have continued to be resilient in Q1 of FY25 (averaging 12% yoy) but there are increasing signs that they are set to slow over the rest of the year, particularly in the ITES segment, given the slowdown in IT spends in India’s overseas markets. 

In addition, there have been fears about a slowdown in foreign investment into India, particularly Foreign Direct Investment (FDI). Although this is a complex story (which we will elaborate in a separate article), the financial market volatility will be a further dis-incentive fore foreign investors.

The biggest worry is the recent sharp depreciation in the Rupee (against the US Dollar), having breached 84 one day, from the average 83.3 levels at which (with some support from RBI) it had remained stable for many months. A depreciating Rupee reduces foreign currency returns of overseas investors, deterring investment. India also 

The good news, however, from the global slowdown, is a loss of consumer demand in the large economies, which has resulted in a drop in metals prices (like steel, copper, etc.). India’s imports a lot of metals and metal products, hence this is likely not just to reduce imports costs, but also help in reducing local commodities prices, and bring inflation further lower. 

On inflation, the prognosis is encouraging. Although food price inflation (vegetables, pulses and even cereals) have remained high and have not seen the seasonal reductions in the winter months, non-food and fuel inflation (the so-called “core” inflation) has moderated very sharply to around 3% levels over the past quarter.

RBI had forecast an average 4.5% CPI inflation in FY25 but current signals suggest that it could be lower around 4.35%, fairly close to the MPC’s 4% inflation target. 

The Indian Monetary Policy Outlook

The economic uncertainties mentioned above will result in a status quo during the policy review, with 2 MPC members continuing to dissent in favour of a rate cut. 

Paradoxically, however, the same economic uncertainties has led to financial markets doing some of the MPC’s work in easing monetary policies.

Economists refer to “financial market conditions” to describe how tight underlying interest rates and economic costs are, which serve to keep borrowing costs high and impede economic growth.

The global turmoil and economic uncertainty have served to lead to expectations of deep rate cuts from central banks.

This in turn has resulted in benchmark interest rates dropping sharply: the US 10 year bond yield has fallen from 4.2% only a few weeks back to 3.8%; the government of India 10 year bond yields have fallen to 6.86% from earlier 7.1%.

All other interest rates will also fall. The Rupee depreciation will also hopefully help in boosting exports. 

More importantly, system liquidity levels have turned to large surpluses from earlier deep deficits, which have reduced short term interest rates. This will, to an extent, help in helping banks garner more deposits, gradually leading to a drop in loan interest rates. 

Over the medium term, MPC will have the space to cut the policy repo rate. We think the first repo rate cut will begin at the December policy review.

Growth remains resilient, but analysis suggests that it can be even higher without overheating demand and leading to another surge in inflation. In the meantime, evolving global conditions will determine the actions of central banks. 

(The author is a Mumbai-based economist and former Chief Economist, Axis Bank. Views expressed are personal)