RBI policy Indranil Pan says Higher remains relevant in the long run not only for the world but also for India

Yes Bank’s Indranil Pan says with a 4 per cent discount on a sustainable basis, it remains a very difficult option for the RBI to change its monetary policy stance to “neutral”, leave alone reducing the policy rate. .

By Indranil Pan, Chief Economist, Yes Bank

This policy was, as expected, without any major surprise elements. Policy rates were kept unchanged, and the monetary policy stance remained “return to accommodation”. The background to this policy was slow inflation, especially as vegetable prices fell. The Governor also indicated that the silver lining is that core inflation is also moderating and is 140 bps below the January 2023 peak.

Moreover, according to the latest Household Inflation Expectations Survey, 3 months ahead inflation expectations have declined by 90 bps, while 1 year ahead inflation expectations have declined by 40 bps. RBI’s assessment on growth is of demand remaining strong in the urban sector and resilient with improvement in the rural sector. Overall, the growth outlook for the year and FY2015 remains unchanged at 6.5 per cent.

However, despite all these positives highlighted for inflation dynamics, there has been no change in the RBI’s stance and its commentary and future guidance remains hawkish. This is because of the significant amount of uncertainties that remain over inflation levels. Area sown in Kharif pulses is weak, Kharif onion production needs to be monitored, demand-supply mismatch in spices is likely to continue. Importantly, El Nino conditions are likely to persist and deepen, impacting global food supplies and prices. FAO’s overall rice price index stood at 141.7 in September 2023, 0.5 percent lower on a nominal basis than in August, but 27.8 percent higher than the index level at the same time last year.

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In the next few paragraphs, I attempt to place the monetary policy perspective of the RBI in the context of the global perspective. There has been a dramatic change in the rate environment around the world. During the Alan Greenspan era, beginning in 2003, our fed funds rate was 1 percent. Subsequently, rates in the US were set at 0 percent during the days of Ben Bernanke and after the Great Recession of 2008.

Overall, from that time through June 2022, the US Fed funds rate was below the CPI inflation rate most of the time. In contrast, from the period 1982–2002, the fed funds rate was above the prevailing rate of inflation almost all the time. To put it more simply, before 2008, the US economy had seen positive real interest rates for significant periods, whereas in the wake of the GFC (Global Financial Crisis), and until recently, the experience has been of negative real interest rates. This is true in the case of ECB also.

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And now, we are once again back in positive real interest rate territory. At its last policy meeting, the economic projections laid out by the US Fed paint a picture of the US economy’s continued resilience. According to estimates, the improved outlook also required the Fed to maintain a hawkish bias in its policy. 12 members now expect the US Fed to raise interest rates by 25 bps in 2023, while 7 others expect a pause. For 2024, the dot plot now indicates only a 50-bps rate cut instead of the 100-bps rate cut expected in the June projections. Thus, the message on “higher for longer” is quite clear and we see the US Fed keeping rates at restrictive levels for longer than in previous cycles.

Importantly, the sanctity of the inflation target rate is gaining prominence in monetary policy making across the world. Same is the condition of India also. With monetary policy communication emerging as an important tool to manage and control inflation expectations, the RBI has reiterated its intention to achieve 4 per cent containment on a sustainable basis. Inflation projections made by the RBI for the remaining part of the year do not point towards achieving the 4 per cent level.

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For Q1FY25, RBI has estimated headline CPI inflation at 5.2 per cent. Moreover, RBI’s CPI projection for FY20 as a whole is 4.5 per cent, while at Yes Bank, we see an average of 4.8 per cent for FY2015. With the relaxation at 4 per cent on a sustainable basis, it remains a very difficult choice for the RBI to change its monetary policy stance to “neutral”, leave alone reducing the policy rate.

Thus, “Longer Higher” remains relevant not only for the world but also for India. It may also be difficult for the RBI to cut rates before the US Fed as the interest differential between India and the US has narrowed to only 250 bps, which would hardly outweigh the expected Indian depreciation on an annual average basis. This interest differential may remain relevant for investors in the Indian debt market, including investors through the JPM Bond index inclusion route.

Bond market participants did not expect any change on the RBI’s liquidity strategy, especially as it reduced the I-CRR (incremental cash reserve ratio). No other measures were announced in this policy. But the RBI once again points to the fact that excess liquidity could increase risks to inflation and financial stability.

With this, RBI brings back the option of OMO (open market operations) sales to manage liquidity. Although such OMOs are unlikely to be calendarised, and would be dependent on emerging liquidity conditions, it has nevertheless spooked the bond market. This has resulted in the 10-year benchmark India G-Sec yield rising by about 12 bps to 7.33 per cent and may remain firm in the near term.

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