Departure from Projected Inflation, RBI MPC to impound excess liquidity

In a highly anticipated decision, the Monetary Policy Committee (MPC) opted to maintain the current policy rates and stance during its August meeting. This move aligns with market predictions and signifies a continuation of the existing monetary policy framework. In a unanimous decision, the Repo rate has been kept unchanged at 6.50 percent.

The Monetary Policy Committee (MPC) has adopted a cautious stance on inflation, considering the recent upward revisions in the Reserve Bank of India's (RBI) Consumer Price Index (CPI) inflation forecasts for the next six months. However, the committee has decided to maintain its forecast for real Gross Domestic Product (GDP) growth without any changes. In a recent development, the forecast for the full year average Consumer Price Index (CPI) inflation in FY24 has been revised upwards by 30 basis points (bps) to reach 5.4 percent. Additionally, the quarterly forecasts for Q2FY24 and Q3 have also been adjusted, with an increase of 100 bps and 30 bps, respectively. These adjustments reflect the latest assessments and projections made by experts in the field.

The Governor of the Reserve Bank of India emphasized the need to take decisive action in order to combat inflation. He stressed the importance of utilizing all available policy tools and moving beyond mere observation. The Governor further emphasized the necessity of maintaining a steadfast commitment to aligning inflation with the target rate of 4 percent. In a significant move, the Reserve Bank of India (RBI) has decided to implement a temporary Cash Reserve Ratio (CRR) hike. Under this new measure, the CRR will be increased to 10 percent of Net Demand and Time Liabilities (NDTL) on the incremental accretion to banks' NDTL between mid-May and end-July.

In a move aimed at tackling the mounting excess liquidity in the banking system, a new measure is set to seize a staggering Rs. 1 trillion. This significant step comes in the wake of the recent withdrawal of Rs. 2000 notes from circulation, which has contributed to the buildup of surplus funds. Amidst the prevailing risk aversion among banks to allocate liquidity in the 14-day VRR window, which serves as a crucial component of the liquidity management framework, this measure has been regarded as a viable alternative. In a strategic move aimed at curbing the anticipated surge in inflation, the central bank has unveiled a new measure. With an eye on the next two quarters, this initiative is poised to tackle the impending inflationary pressures head-on. In cases of supply-side induced inflation, the presence of a persistent surplus liquidity overhang has the potential to exacerbate inflationary pressures. In a striking parallel to its actions in 2016, the Reserve Bank of India (RBI) has once again resorted to a similar measure. This move comes as the banking system finds itself grappling with a sudden surge in liquidity surplus, a situation that bears an uncanny resemblance to the aftermath of the demonetization announcement.

Governor Das acknowledged that the process of transmitting policy rate hikes to fresh lending and deposit rates is still in development. The potential justification for implementing this liquidity reduction measure could also be attributed to the fact that it aligns with the 250 basis point increase in the Repo rate, thereby facilitating effective transmission. The recent increase in the inflation trajectory, coupled with robust domestic growth factors, indicates that the Monetary Policy Committee (MPC) has the ability to sustain and prolong the current pause for the remainder of the year. However, this is contingent upon the actual inflation figures aligning with the projected path.

The Monetary Policy Committee (MPC) statement has revealed a revised inflation trajectory that sheds light on the Reserve Bank of India's (RBI) updated expectations. According to the statement, the RBI now anticipates inflation in the second quarter to average 6.2 percent. This figure marks an increase from the previous forecast of 5.2 percent, as stated in the June statement. The recent surge in prices can be attributed to a significant rise in the cost of vegetables, with tomatoes being particularly affected during the months of July and August. However, experts predict that the overall inflation rate will gradually decrease over the next three quarters, reaching a level of 5.2 percent by the first quarter of the fiscal year 2025. With the rapid turnover of vegetable crops, it is expected that prices will experience a decline in the coming months as the supply stabilizes. Cereals and pulses are also experiencing the strain of food inflation.

The sowing of summer crops is making steady progress, mirroring the pace seen last year. This positive development can be attributed to the recent increase in monsoon activity, which has provided much-needed support to the agricultural sector. The timely arrival of monsoons is expected to play a crucial role in curbing food inflation in the coming months. Additionally, the government's proactive measures to manage the supply of essential commodities have further contributed to this favorable outlook. Uneven rainfalls and disruptions caused by El-Nino present a potential risk. The recent stabilization of crude oil prices presents a potential threat to fuel inflation.

Governor Das highlighted the significant easing of core inflation, surpassing 100 basis points since its peak in January 2023. This development brings a sense of reassurance. According to the RBI's enterprise surveys, there is a potential increase in output prices among manufacturing, services, and infrastructure firms. The potential outcome of this situation is an increase in core inflation, as it has been observed to ease from January to June but is expected to stabilize at around 5 percent. In a balanced assessment, the risks to the baseline inflation trajectory are perceived to be evenly distributed.

The baseline growth trajectory remains unchanged. The projected real GDP growth for FY24 is expected to reach 6.5 percent, according to recent forecasts. However, analysts anticipate a slowdown in growth during the second half of the fiscal year, with an average growth rate of 5.9 percent. This is in contrast to the first half, which experienced an average growth rate of 7.3 percent. Despite the potential risks posed by weakening external demand conditions, domestic drivers of growth continue to remain strong. According to the Reserve Bank of India (RBI), investment activity is becoming more widespread, thanks to a rapid increase in public investments during the first quarter. The central government's capital expenditure has surged by 59% year-on-year, while 20 states have witnessed a remarkable 74% year-on-year increase in their capital expenditure. The resurgence of private capital expenditure is becoming increasingly apparent in specific sectors, while the manufacturing sector continues to maintain capacity utilization levels that surpass their long-term average. The robust financial positions of banks and corporations, coupled with a positive outlook for business sentiment, create a conducive environment for a resurgence in capital expenditure.

Private consumption continues to display robust growth. Urban demand indicators continue to show consistent growth, while rural demand indicators are indicating a potential recovery in rural demand. The weakening of external demand and the presence of various challenges such as weak global demand, financial market volatility, geo-political tensions, and geo-economic fragmentation, are posing a risk to the current growth trajectory. In terms of growth, risks are perceived to be evenly balanced.

In the face of challenging conditions in the external sector, the key to sustaining growth lies in an unwavering commitment to price and financial stability. In the face of external challenges, a combination of factors including sufficient foreign exchange reserves, a decreasing need for external financing through a shrinking current account deficit, relatively low inflation, continued efforts to consolidate fiscal policies, and a stable policy environment with a flexible exchange rate, are poised to mitigate the impact of these external pressures.

In order to gradually bring inflation down to the target level of 4 percent, monetary policy will need to maintain a vigilant stance. The proposed measure aims to bolster macro-financial stability, ensuring sustained growth of over 6 percent and facilitating the attainment of higher growth levels. In light of the prevailing circumstances, it is imperative that policy rates remain unchanged at their current levels. Inflation Anticipated to Stay Above 5% in the Coming Quarters, Bolstering the Argument for a Prolonged Pause and Data-Driven Action

In order to gradually bring inflation down to the target level of 4 percent, monetary policy will need to maintain a vigilant stance. The proposed measure aims to bolster macro-financial stability, ensuring sustained growth of over 6 percent and facilitating the attainment of higher growth levels. In light of the prevailing circumstances, it is imperative that policy rates remain unchanged at their current levels. Inflation Anticipated to Stay Above 5% in the Coming Quarters, Bolstering the Argument for a Prolonged Pause and Data-Driven Action

In addition, the potential for a notable departure from the projected inflation trajectory is worth noting. This could be driven by robust economic expansion surpassing initial expectations and an increase in persistently high core inflation. Such a scenario may heighten the likelihood of additional measures to tighten monetary policy. The unaltered policy position of withdrawing accommodation opens up the possibility. In the realm of monetary policy, a prolonged pause has become the norm. However, the upcoming October meeting of the Monetary Policy Committee (MPC) may disrupt this trend if there are indications of persistent inflationary pressures.