Status Quo, But “Unwavering Focus” On Inflation Will Delay The First Repo Rate Cut

The repo rate (or the rate at which commercial banks borrow from the central bank) was held at 6.5 per cent (since February 2023), retaining the stance of “remaining focused on withdrawal of accommodation to ensure that inflation progressively aligns with the target, while supporting growth”.

Also as expected, the forecasts of FY 2024-25 GDP growth and consumer price index (CPI) inflation were held at 7 per cent and 4.5 per cent. However, there was a change in the quarter-wise inflation trajectory beyond the optics of the headline number. 

The present forecasts for the four quarters of FY 2024-25 are now 4.9 per cent, 3.8 per cent, 4.6 per cent and 4.5 per cent (versus the February 2024 forecasts at 5 per cent, 4 per cent, 4.6 per cent and 4.7 per cent). This resulted in a drop in the second decimal of the annual forecasts to 4.45 per cent (from the earlier 4.54 per cent), a drop of about 90 basis points or bps (one bp is one-hundredth of a per cent). 

Despite this, the tone and language of the Governor’s statement indicated that the MPC was focused more on bringing inflation down to the target of 4 per cent and was more sanguine on the resilience of growth and demand momentum. 

The statement was peppered with phrases like “robust growth prospects provide the policy space to remain focused on inflation, monetary policy must continue to be actively disinflationary to ensure anchoring of inflation expectations and remain unwaveringly focused on price stability”. 

Inflation expectations are probably even more important to any central bank than actual inflation. This is because these play out in multiple economic activities, particularly wage negotiations in labour markets.

Note that a critical factor in the Bank of Japan’s decision to hike its policy rate in March, after 16 years, was the unprecedented 5.2 per cent increase in Japanese workers' wages. 

Fortunately, household inflation expectations in India remain anchored: 1-year ahead, expectations have fallen by 120 bps since September 2022. 

The MPC has also been emphatic that inflation needs to “durably” fall to the 4 per cent target, not just for a few months or a quarter, for the members to consider a change in the restrictive stance. Using the parable of the (inflation) elephant in the room, the Governor warned that “till this is achieved, [MPC’s] take remains unfinished”. 

In India, the main challenge is continuing high food inflation. Normally, prices of fruits and vegetables fall during the winter season, but this year, they didn’t drop much. With warnings of a heat wave during the summer, cereals and vegetable prices are likely to increase. 

Geopolitical tensions are likely to keep crude oil prices high, which will affect many non-petrol and diesel fuels, and lubricants. Fodder prices remain high, affecting prices of milk and poultry.

The good news is that the India Meteorological Department forecasts a shift in global El Niño conditions to neutral during April to June and then to La Niña over July to September, which is good for a normal monsoon. 

Also repeated was the warning of global central banks that while developed markets' “inflation is moving closer to targets, but the last mile of disinflation is turning out to be challenging”, in particular, services inflation, which is a large component of the inflation baskets of those economies.

As a consequence, global central banks are pushing back against market expectations of an early and deep rate cut. 

One final caveat in the statement was that the Reserve Bank of India (RBI) is still trying to ensure “fuller transmission” of the changes in policy rates into bank lending rates. 

This has two implications. As of now, about 53 per cent of total bank loans are priced external interest rate benchmarks (largely the repo rate and some to the 3-month Treasury bill rate). These apply to all retail loans (personal, credit cards, auto loans, etc.) and loans to micro, small and medium enterprises.  

Corporate lending, on the other hand, is priced at what is called a Marginal Cost of Lending Rate (MCLR), which is derived using a complex formula based on the cost of deposits, operating costs, and other factors. 

Hence, first, it is implied that the MPC will patiently wait till banks pass on the full cost of repo rate increases to corporate borrowers, which might take some time. 

Second, and more important, are the implications for RBI’s management of system liquidity. 

This caveat suggests that system liquidity will still be maintained at a slight deficit, so that the cost of acquiring new deposits remains relatively high, which banks will be forced to pass on to corporate borrowers so that they are able to retain their interest rate margins. 

Till the policy was announced, it had appeared that RBI was open to shifting to slightly surplus liquidity levels, permitting short-term interest rates to remain at the repo rate (or a little below). 

In the last months of 2023 and early 2024, RBI had maintained significantly negative system liquidity, causing near-term interest rates to touch or exceed the Marginal Standing Facility (MSF) rate, the upper end of the policy rate corridor, which was an indirect method of further tightening policy beyond the repo rate at 6.5 per cent. 

Liquidity has now been eased to a slight deficit (or even a surplus) with the use of instruments like Variable Rate Repo (VRR) auctions, causing overnight rates to fall to the mid-corridor repo rate or even below. 

The question now—both in the global and Indian context—is when will the monetary policy cycle pivot towards rate cuts?

Given the warnings read together with the RBI’s inflation forecasts, it seems we need to get used to a “higher for longer” narrative. The 4.6 per cent and 4.5 per cent inflation forecasts for Q3 and Q4 of FY 2024-25 suggest that a hold on the repo rate will persist till at least the December 24 review.

Paraphrasing a Federal Reserve member, MPC can afford to be patient, so long as the economy holds up.  

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