NO Rate Cut but Dovish Undertone likely

On?August 1, in a closely-run decision, the Bank of England lowered its main interest rate by a quarter percentage point to 5 per cent, marking the first rate cut since the Covid pandemic outbreak in March 2020. In a five-to-four verdict, BoE Governor Andrew Bailey joined four other policymakers in bringing the rate down from a 16-year high.

The decision to cut interest rates is "an important moment in time", Bailey said, but warned people not to expect a sharp fall in the policy rate in the coming months.

The day before,??the US Federal Reserve’s rate-setting body, the Federal Open Market Committee (FOMC), unanimously voted to keep the policy rate unchanged at 5.25 per cent. The decision to maintain the rate at its 23-year high was on expected lines, but there have been hints of a possible rate cut in September. The forward guidance remains?unchanged. However, the?policy statement, which had so far emphasised containing inflation, for the first time, spoke about its “dual mandate” – containing inflation and generating employment.

A dovish press conference followed the FOMC meeting. Fed Chairman Jerome Powell was emphatic that the prospects of a rate cut in September remain firmly in place. The case for cutting rates could open up “if inflation moves down in line with expectations, growth remains reasonably strong, and the labour market remains consistent with its current conditions”.

While the world’s largest economy braces for a rate cut two months ahead of its 60th quadrennial presidential election, what will the Reserve Bank of India (RBI) do next week at the meeting of its Monetary Policy Committee, a fortnight after the Union Budget? The last policy meeting took place in June, immediately after the general elections.

The RBI must be pleased with the Budget, which has outlined the government’s commitment to sticking to the fiscal consolidation path. The estimated fiscal deficit for FY25 has been reduced from 5.1 per cent, presented in the Interim Budget, to 4.9 per cent. This has been done without compromising on the budgeted capex outlined in the Interim Budget – Rs 11.1 trillion, or 3.4 per cent of GDP. In FY26, the fiscal deficit is expected to go down to 4.5 per cent.

Following the drop in the fiscal deficit projection, the estimated gross and net market borrowing of the government in FY25 has been marginally pared to Rs 14.01 trillion and Rs 11.63 trillion, respectively, from Rs 14.13 trillion and Rs 11.75 trillion projected in the Interim Budget.

The progress of the monsoon is another?good??story. The?not-so-good?story is the trajectory of retail inflation. After remaining below 5 per cent for?three successive months till May, retail inflation?rose to 5.08 per cent in June.?Rising food inflation played the spoiler, while core inflation, or non-food, non-oil inflation, remained at a historically low 3.1 per cent, based on the 2012 base year series.

A combination of heatwaves in certain parts of India and a weak or delayed monsoon season led to a spike in food prices, but the pressure will ease as the progress of the monsoon is on course.

Against this backdrop, what can we expect from the RBI? In June, it had kept the policy rate unchanged at 6.5 per cent for the eighth consecutive time.

The June policy projected retail inflation for FY25 at 4.5 per cent – 4.9 per cent in the first quarter; 3.8 per cent in the second; 4.6 per cent in the third; and 4.5 per cent in the fourth.?The policy also raised the GDP growth projection for FY25 to 7.2 per cent, up from 7 per cent estimated in April.

The policy statement?ended, saying:?“On inflation, we are on the right track, but there is still work to be done… with growth holding firm, monetary policy has greater elbow room to pursue price stability to ensure that inflation aligns to the target on a durable basis.” The inflation target is 4 per cent, with a 2-percentage point band on either side.

While inflation is expected to drop in the second quarter of FY25, beginning this month, thanks to the base effect, the RBI is unlikely to take its eyes off it and rush for a rate cut. In fact, RBI Governor Shaktikanta Das doesn’t miss a single opportunity to emphasise the central bank’s commitment to bottle the inflation genie.

Meanwhile, two interesting observations in the RBI’s July Bulletin have excited the community of analysts.

The chapter on the State of the Economy, written by a group of central bankers led by Deputy Governor Michael D Patra, also a member of the MPC, makes it clear that the aim continues to be aligning inflation with the target of 4 per cent. But, “this does not imply that inflation should reach 4 per cent and stay there before monetary policy considers a change in stance; instead, based on a careful evaluation of the balance of risks, an enduring movement towards the target should provide signals to forward-looking monetary policy to respond...”

Another article discusses the level of the natural or neutral rate of interest. It finds an “upward shift” while updating the estimates of the natural rate of interest for India with post-pandemic data, driven by the growth of potential output. The estimate of the natural rate for the fourth quarter of FY24 is 1.4-1.9 per cent, higher than the earlier estimate of 0.8-1.0 per cent for the third quarter of FY22.

Assuming a 4.5 per cent one-year forward inflation rate, at a 1.4-1.9 per cent neutral rate, the policy rate should be 5.9-6.4 per cent. This?is not far off from the current?rate of 6.5 per cent. So, rate cuts can be ruled out at this point, but many are expecting a change in stance, from “withdrawal of accommodation” to “neutral”.

The rate cut?can follow?in December with a new MPC at the helm. The current committee will be reconstituted in October with three new external members.

The market expectation is evident in the slide in bond yields. The 10-year bond yield closed last Friday at 6.89 per cent, its two-year low. Bond yields drop as prices rise, driven by demand.

Indeed, the key factor leading to the demand for bonds is the revision in the norms for the computation of the so-called?liquidity coverage ratio,?which refers to a stock of high-quality liquid assets (read government securities) that banks need to maintain to tide over a hypothetical 30-day stress scenario in the event of an outflow of deposits. The revised guidelines are effective from FY26.

Meanwhile, a?dovish Fed and the rise in the US unemployment rate in July saw US bond yields tumbling last Friday, rattling global equity markets.

Will this impact the MPC decision??In a recent interview with a financial daily, the RBI governor said the central bank’s focus is on price stability (maintaining inflation at 4 per cent), keeping in mind the objective of growth.

Even with the current policy rate, growth is very robust. After an average growth of 8.3 per cent in the past three years, the RBI expects the Indian economy to grow by 7.2 per cent this year. In the first quarter, it could be as high as 7.4 per cent. When growth momentum is sustained, it’s time to focus on inflation. The target is to contain inflation, keeping growth in mind.

Das is?also?not willing to give much importance to the neutral rate, which he describes as “abstract” and “theoretical”.

Don’t expect a rate cut. The stance could change, and if it doesn’t, the undertone of the policy is expected to be dovish.

This column first appeared in Business Standard.

The writer is a Consulting Editor of Business Standard and Senior Adviser of Jana Small Finance Bank

Writes Banker's Trust every Monday in Business Standard.

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