India's Economic Rollercoaster: Is the RBI Ready to Slash Rates Amid Rising Inflation?

Introduction

This article looks at the current economic situation in India. It talks about inflation, growth in GDP, and the recent decisions made by the Reserve Bank of India (RBI) about money policy.

We will discuss inflation factors like food and fuel prices, how well GDP is holding up despite risks, and what to expect from RBI's rate cuts. We will also look at bond yields, foreign investments, and how global events might affect India.

The goal is to provide a simple but complete view of India's economic condition.

Right now, inflation and GDP growth trends in India show a mixed picture. The Core Consumer Price Index (CPI), which excludes food and fuel prices, has stayed below 4% for eight months straight. But the RBI is still concerned about food inflation, as it makes up almost 46% of what people spend money on.

The recent rains have eased some worries about food inflation. However, uneven rainfall and longer monsoon seasons have increased the risk of crop damage, meaning food prices may still go up, even though things seem calmer for now.

We also need to realize that these climate changes are part of a bigger problem with agriculture in India, which still relies heavily on the monsoon. To reduce these risks, India should think about improving irrigation systems and using modern farming techniques that can handle weather changes better.

CPI Inflation

Food prices have been rising, while fuel prices have slowed down. But there are also external risks to inflation because of conflicts, like the one between Iran and Israel. This conflict could cause issues with supply chains and impact global energy prices, leading to more inflation in India. One way to handle this is by investing more in renewable energy so that India is less affected by global energy problems. Finding other energy sources and keeping reserves ready are also important steps to manage these risks.

Oil prices had gone down to around $70-71 per barrel in late September but have now risen to $77 per barrel because of the issues in the Middle East. Although fuel is only 7% of the CPI basket, higher fuel prices could affect other sectors. For example, logistics, manufacturing, and retail are all vulnerable to rising costs. This might mean the government needs to look at subsidies or tax cuts to help keep prices stable.

Also, China recently took measures to boost its economy, which caused global commodity prices to go up, especially for metals. This rise could increase India's Wholesale Price Index (WPI) inflation, which has averaged 2.1% so far in FY25. Reducing how much India depends on imports and increasing domestic production of important metals could be key to managing price changes.

Another major issue with inflation in India is problems in the agriculture supply chain. Inefficiencies in storage, transportation, and the presence of too many intermediaries all contribute to price increases for consumers. By improving storage facilities, cutting down the number of middlemen, and making transportation better, we could help stabilize food prices.

The government’s role is also crucial. It sets the Minimum Support Prices (MSP) for crops to help farmers, but if not done correctly, it can cause market problems. Finding the right balance to help farmers without pushing up consumer prices too much is key to long-term stability.

GDP Growth Resilient, but External Risks Remain

India's GDP growth slowed down to 6.7% in Q1 FY25, compared to 7.8% in Q4 FY24. This slowdown happened partly because the previous year's growth was very high. Still, the economic outlook is positive, and there is room for monetary policy to align inflation with a sustainable target of 4%. But looking deeper, we need to see how much of the GDP growth is driven by government spending versus private investments and consumption. Relying too much on government spending might not be sustainable.

India's manufacturing sector has seen mixed results. While industries like pharmaceuticals and automobiles are doing well, others like textiles are struggling because of global competition and rising input costs. Expanding Production Linked Incentive (PLI) schemes to medium-scale industries could boost domestic production and help these struggling sectors.

The services sector is a big part of India’s GDP and has shown resilience, especially in areas like IT, telecommunications, and finance. But industries like tourism and hospitality have not fully recovered from the pandemic. By addressing issues like skills mismatches, we could make the services sector even stronger and create more jobs.

To build on the growth in services, we also need to address challenges in other sectors like agriculture and manufacturing, which need better policies to grow and contribute more to GDP.

However, there are still risks to growth, like global slowdowns in key markets and rising tensions in the Middle East. Finding new export markets and building stronger trade relationships could help India protect itself from these global problems.

Domestic consumption also plays an important role. India has a huge consumer market, but income inequality is still a big problem. By improving access to education, healthcare, and social services, the government can help boost consumption. Also, making banking services and digital payments more accessible can help support consumer spending.

RBI Monetary Policy: Real GDP Forecast and Rate Cut Expectations

The timing of any interest rate cut by the RBI is uncertain—it could be in December 2024 or February 2025—but it is expected to be small, around 50 basis points in two stages. The RBI estimates that the natural (neutral) rate of interest is between 1.4% and 1.9%. It’s important for the RBI to look at global trends while deciding on this, as global monetary policies often affect the Indian economy.

With average inflation projected at 4.5% for FY25, the real interest rate is close to 2%. This provides room for a small rate cut. However, because of the current uncertain environment, the RBI needs to be careful. A gradual and well-communicated approach to rate cuts can help avoid bubbles in markets like real estate, which has faced price volatility before.

The RBI also needs to think about global interest rates. If central banks in countries like the US or the EU raise rates while the RBI lowers them, it could cause capital to flow out of India, putting pressure on the rupee. So, a careful balance that keeps in mind global trends is necessary.

10-Year Benchmark Yield Trends

Even without any change in rates, the 10-year government bond yield has dropped from 7.19% in January 2024 to 6.92%. This shows that the bond market has already expected a rate cut. This response from the bond market can be seen as a good sign, reflecting optimism about fiscal health and inflation control. However, if expectations are too optimistic, it could cause abrupt changes and market instability.

The decline in yields is partly due to limited government borrowing and the inclusion of Indian bonds in major bond indexes, which increased demand. We need to look at whether this decline is sustainable or driven just by liquidity, as the latter could reverse quickly.

Domestic investors also play a big role in shaping yield trends. Organizations like the Employees' Provident Fund Organisation (EPFO), insurance companies, and mutual funds have been major buyers of government securities. Encouraging more retail participation through tax incentives and savings schemes could further stabilize yields.

The link between bond yields and government fiscal policy is also important. Efforts to reduce the fiscal deficit while still supporting growth are key to keeping bond yields low. Any failure to meet fiscal targets could put upward pressure on yields.

Foreign Portfolio Investments (FPI) in Indian Bonds

Foreign portfolio investments (FPIs) into Indian bonds have turned positive after Indian bonds were included in the JPM GBI-EM Bond Index. As of CY24, foreign investments into Indian bonds totaled ?108,000 crore (about $13 billion). Another recent inclusion into the FTSE Emerging Markets Bond Index will likely boost investments further. However, we need to recognize the volatility of FPIs—they can change direction quickly in response to global risks. Strengthening domestic investments is important to keep the market stable.

Global liquidity conditions also have a big impact on FPI flows. If major central banks move towards easier monetary policies, more liquidity could flow into emerging markets like India. But if liquidity tightens suddenly, these flows could reverse. Building a strong domestic debt market with more participation from long-term investors can help reduce the risks of such volatility.

Managing the exchange rate is also important to make Indian bonds attractive to foreign investors. A stable exchange rate reduces currency risk, which makes Indian bonds more appealing. Maintaining a healthy level of foreign reserves is also crucial as it acts as a buffer against currency fluctuations.

India in a Goldilocks Period, but Geopolitical Risks Persist

India’s economy has recovered well after the pandemic, contributing over 18% to global growth. Inflation is on a downward path, foreign exchange reserves are at record levels, and the corporate and banking sectors are doing well. However, fiscal consolidation could lead to reduced government spending, which has been a key driver of growth. A balanced approach that cuts waste but maintains essential spending could be the best path forward.

While macroeconomic conditions look favorable, geopolitical risks remain, such as tensions in the Middle East and the upcoming US elections. Even small changes in these situations could have big impacts, so building resilience through reforms like reducing oil dependency and diversifying trade partners is crucial.

India’s services exports have been a big factor in external stability, especially IT and BPO services. Encouraging growth in newer areas like fintech, healthtech, and edtech could diversify our services exports even further.

The banking sector also needs attention. Banks have made good progress in reducing bad loans, but more work is needed to avoid problems in the future. Ensuring banks have enough capital and improving governance in public sector banks will help sustain progress.

The RBI kept rates steady in October 2024, choosing not to cut them yet, but it did change its stance to “neutral.” This means the RBI could be ready to cut rates in FY25 if inflation stays under control.

Key Policy Highlights

• The RBI kept GDP growth and inflation projections for FY25 at 7.2% and 4.5%.
• The move to a “neutral” stance shows that the RBI is open to cutting rates if inflation stays in check.
• Governor Shaktikanta Das stressed the need for caution, especially with risks from weather events and geopolitical conflicts.

Conclusion

To sum up, India’s economy shows many positive signs, like decreasing inflation and solid GDP growth, but there are still challenges. Geopolitical tensions and global uncertainties could hurt growth and raise inflation risks. The RBI’s careful approach, holding rates while adopting a neutral stance, shows a focus on balancing growth and stability.

To keep the momentum, India must address both internal and external challenges. Internally, the country should invest in infrastructure, technology, and people. Improving agriculture, encouraging private investment, and making the labor market more efficient are key areas that need attention. Externally, building resilience by reducing dependency on limited markets and expanding exports is also critical. A stable exchange rate and strong foreign exchange reserves will help attract investments.

Looking ahead, India faces a mix of opportunities and challenges. By keeping a balanced policy, encouraging innovation, and investing in crucial sectors, India can stay on a path of sustainable growth and strengthen its position in the global economy.