Status Quo On Policy Rate, But Will RBI Change The Stance?


In May 2022, Reserve Bank of India (RBI) Governor Shaktikanta Das said in an interview that expectations of a rate hike in the next policy meeting were a no-brainer since inflation was a major area of concern even as economic recovery was steady and gaining traction.

This was weeks after the first rate hike in the current round, from 4 per cent to 4.40 per cent, in an off-cycle meeting of the Monetary Policy Committee (MPC), the RBI’s rate-setting body. It happened barely 12 hours before the US Federal Reserve raised its policy rate by 50 basis points (bps), the highest in 22 years, to tackle the worst inflation in four decades. In the US, the decision to raise the rate followed a 25 bps hike in March 2022, a first since late 2019. One bps is a hundredth of a percentage point.

Last month, the Federal Reserve announced its 10th interest rate hike in just little over a year, taking the Fed funds rate to a target range of 5 per cent-5.25 per cent. Even though the minutes of the Federal Open Market Committee hinted at the US central bank pivoting to a pause, there could be yet another rate hike because inflation and consumer spending in the US accelerated in May.

Be that as it may, a status quo on the policy rate at the next MPC meeting is a no-brainer. Why? The current situation does not warrant a rate hike. The retail – or consumer price index (CPI) – inflation in April dropped to an 18-month low of 4.7 per cent, falling sharply from 5.66 per cent in March. The core – or non-food, non-oil – inflation too dropped to 5.06 per cent in April, its 35-month low. At -0.92 per cent, the wholesale price index (WPI) inflation in April was the lowest since June 2020.

Indeed, WPI doesn’t have a bearing on the monetary policy but its pass-through is expected to help soften the CPI further. Also, the CPI is turning out to be softer than anticipated, and core inflation seems to be losing momentum after rising persistently over the past 10 months.

At the last meeting in April, all six MPC members unanimously decided in favour of keeping the policy rate unchanged at 6.5 per cent. It was a “hawkish” pause and Das’s statement repeatedly emphasised the central bank’s “readiness to act, should the situation so warrant”.

The CPI will drop further in May and continue to remain low till October, largely on account of the base effect. Between January and October 2022, the CPI moved in the range of 6.01 per cent and 7.79 per cent.

While there is no doubt that the RBI will continue with the pause, the curiosity is around the stance of the monetary policy. At its last meeting, the MPC decided to stick to its stance of “withdrawal of accommodation”. If the central bank opts for a pause for the second time in a row, should it change the stance to neutral? Some economists feel it should, while some others recommend a fine-tuning of the stance – sticking to “withdrawal of accommodation” but adding “data dependence” to it.

Excess liquidity in the banking system narrowed to about Rs 74,000 crore in early May from about Rs 3 trillion in April, according to data compiled by Bloomberg Economics. The RBI injected about Rs 46,800 crore into the banking system on May 19 through its repo window, the first such infusion since March.

I would not expect the RBI to change its stance at this MPC meeting. The withdrawal of the Rs 2,000 currency notes from circulation is expected to add around Rs 1 trillion to liquidity – even if less than one-third of the highest-value currency note in circulation is deposited with banks. The RBI’s handsome dividend payout to the government also adds liquidity in the system. In fact, riding on higher government spending, the systemic liquidity crossed Rs 1.75 trillion on the last day of May, easing the overnight call money market rate.

Will the RBI pare its inflation projection for the year in this policy? In February, it had estimated 5.3 per cent retail inflation for the year. This was cut marginally to 5.2 per cent in April with the risks evenly balanced. For the time being, it may leave it unchanged; if at all, it may pare it by just another 10 bps to 5.1 per cent.

Indeed, the CPI will remain below 5 per cent in the first half of FY2024, but it will rise in the second half because of the base effect. It’s too early to cut the average inflation projection to below 5 per cent as some analysts have been expecting.

The April policy projected the real GDP growth for FY2024 at 6.5 per cent. For the time being, the RBI may not change the growth estimate. A stronger-than-expected fourth quarter growth has lifted the GDP growth for the last financial year to 7.2 per cent, higher than the RBI’s forecast of 7 per cent.

Since the first rate hike in May 2022, the repo rate has been raised by 250 bps, from 4 per cent to 6.5 per cent. This was preceded by the introduction of the standing deposit facility, or SDF, in April 2022, which is 40 bps higher than the now defunct reverse repo rate. Thus, the effective rate hike since has been 290 bps.

The RBI may not like to let its guard down easily while it evaluates the cumulative impact of these rate hikes, even though a section of the market has started speculating on the timing of the first rate cut.

They are also encouraged by the convergence of yields of different maturities of government securities. Is this pointing to a dramatic shift in inflation expectations? Is the battle against inflation over?

In the second week of May, yields on government securities ranging from the 91-day treasury bills to the benchmark 10-year maturity security converged to a narrow range of 5 bps (from 300 bps at the end of 2021). With this, the term spreads in the bond market, which had been widening since the second half of 2019 before they started easing in 2022, have compressed to a multi-year low.

I guess this is happening more for a technical reason – too much demand on the longer end, mainly from insurance companies, pension funds and provident funds are leading to the convergence. This also signifies the deepening of the market.

Currently, the spread between the one-year treasury bill and 10-year bond is less than 10 bps. This suggests that the market is pricing a rate cut in the medium term.

The war against inflation is not over yet. There are too many variables to watch out for – El Nino, the monsoon (patchy but normal monsoon is expected), the oil price and the behavior of the local currency vis-à-vis the dollar (it has performed well so far). While 6.5 per cent is the terminal rate for sure, we may have to wait till the February 2024 MPC meeting to see the first rate cut. Or, will it happen in December? Let’s not speculate now.

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