RBI's Tough Call

The Reserve Bank of India (RBI) has maintained its repo rate at an 8-year high of 6.5%, despite core inflation being at a 12-year low of 3% in May 2024. This decision has significant implications for the economy, the bond market, and the future of India's monetary policy. Understanding the RBI's stance requires a detailed analysis of various economic indicators, global trends, and internal policy debates.

Understanding Repo Rate and Its Economic Impact

The repo rate is the rate at which the RBI lends money to commercial banks. It is a crucial tool for controlling inflation and stimulating economic growth. A lower repo rate reduces the cost of borrowing, encouraging businesses and consumers to spend and invest, thereby boosting economic growth. Conversely, a higher repo rate makes borrowing more expensive, which can help cool down an overheating economy and control inflation.

However, the current scenario presents a paradox. The core inflation, which excludes volatile food and fuel prices and is a more stable indicator of long-term inflation trends, is at its lowest in over a decade. Yet, the RBI maintains a high repo rate, diverging from the trend seen in other major economies where central banks have started to lower rates.

Core vs. Non-Core Inflation

To understand the RBI's stance, it's essential to differentiate between core and non-core inflation. Core inflation measures the changes in the costs of goods and services excluding food and energy, which are subject to seasonal fluctuations. This measure reflects the underlying long-term trend in the price level and is more responsive to monetary policy.

Non-core inflation, on the other hand, includes food and fuel prices, which are more volatile and influenced by supply-side factors. These components can experience significant price swings due to weather conditions, geopolitical events, and other disruptions that monetary policy cannot easily mitigate.

Headline inflation combines both core and non-core components, providing an overall picture of inflation in the economy. Recently, headline inflation has been pushed up by rising food prices, contributing to the RBI's cautious approach.

The Current Economic Landscape

Despite the low core inflation, several factors have influenced the RBI's decision to maintain the repo rate at 6.5%.

1. Global Monetary Trends: Many central banks, including those in the European Union, Canada, and several emerging markets, have started lowering their policy rates. However, the US Federal Reserve and the Bank of Japan have kept rates unchanged. The RBI monitors global trends but prioritizes domestic economic conditions in its decisions.
2. Weak Domestic Consumption: India's growth has been below potential, with weak consumption trends. Per capita consumption growth is at a 12-year low, and aggregate demand continues to lag GDP growth, expanding at only half the rate of overall growth. This weak consumption demand has been a significant concern for the RBI, which aims to balance the need for economic growth with the risk of inflation.
3. Food Inflation Concerns: Despite low core inflation, food inflation remains a significant concern. Prices of vegetables, pulses, cereals, and other essential items have been rising, contributing to the persistence of non-core inflation. The RBI aims to avoid an overreaction to these transitory shocks but remains vigilant against the potential for these to spill over into broader inflation expectations.
4. Bond Market Dynamics: The bond market has been signaling expectations of rate cuts, with the yield on the benchmark 10-year government bond falling below 7% since May 22. The market's optimism is driven by expectations of India's inclusion in key global bond indices, a benign current account deficit, and favorable demand-supply dynamics. However, the RBI remains cautious, balancing the need to support economic growth with the risk of reigniting inflation.

Policy Debates within the RBI

The Monetary Policy Committee (MPC) is divided on the issue. Two members, Ashima Goyal and Jayanth R. Varma, advocate for a rate cut, arguing that the elevated real repo rate is detrimental to potential growth. They emphasize that maintaining restrictive policy for too long could sacrifice future growth. Goyal notes that expected growth for 2024-25 is around 7%, below the 8% achieved in the previous fiscal year.

Goyal and Varma argue that the high real repo rate, which is the nominal rate adjusted for inflation, is dampening economic activity. They highlight that consumption growth is weak and that the economy is not performing at its full potential. Goyal’s research indicates that a 1% increase in the real interest rate could reduce growth by 21 basis points. She cites historical data showing that overly restrictive monetary policy has previously led to significant growth sacrifices.

In the June 5-7 MPC meeting, Goyal voted for a 25-basis point rate cut and a change in stance to neutral, arguing that even with these changes, monetary policy would remain disinflationary and help bring inflation closer to the target. Varma also supported a 25-basis point rate cut, warning that maintaining a restrictive policy for too long could lead to a growth sacrifice not just in the short term but also in the subsequent fiscal year (2025-26).

On the other side of the debate, Governor Shaktikanta Das and Deputy Governor Michael Patra, along with two other MPC members, stress the need for caution. They argue that food price shocks could disrupt the inflation fight and that the speed of disinflation has been slower than expected. The majority view within the MPC is that a continued vigil is required to ensure inflation remains within the target range of 2%-6%.

Das pointed out that while headline CPI inflation is moderating, the pace is slow due to persistent food inflation. He emphasized that monetary policy must remain alert and maintain a restrictive stance to mitigate the risks posed by recurrent supply-side shocks, particularly in the food sector.

The Bond Market Signal

Despite the RBI's cautious stance, the bond market is betting on rate cuts sooner rather than later. The yield on the benchmark 10-year government bond fell below the psychologically important 7% mark on May 22 and has remained mostly around 6.9% since then. On the charts, the 10-year yield remaining below the 20-day and 20-week exponential moving average has already signaled a downtrend in rates.

India’s inclusion in key global bond indices, a benign current account deficit, sovereign ratings upgrade, and government adherence to the fiscal glide path are positives for the bond market. These factors make India’s interest rate differential with the US less significant than in the past. The market sentiment is that the RBI will eventually align with global trends and lower rates, even as the central bank remains cautious for now.

Divergent Global Paths

Globally, central banks have started to diverge on their policy to reverse historical series of rate hikes. Earlier this month, the European Central Bank cut its key interest rates by 25 basis points, and several other central banks, including those in Canada, Sweden, Chile, Hungary, Brazil, and Peru, have also reduced rates in their recent meetings. However, the US Federal Reserve and the Bank of England have kept rates unchanged, with the Bank of Japan continuing on a rate-hiking path.

This divergence highlights the complexity of global economic conditions and the need for central banks to tailor their policies to domestic realities. RBI Governor Shaktikanta Das has repeatedly stated that India’s rate decisions are based on domestic factors like growth and inflation. "Even if the US eases monetary policy, we may not," Das said on June 7, emphasizing that India's policy is guided by its own economic conditions.

Conclusion

Core inflation is at its lowest level in the current CPI (2012) series, and the spread with the repo rate is the highest since 2012. As consumption growth lags and GDP rise in FY25 is estimated lower than last year, the time has come for the RBI to take a decisive path. India's economy has the potential to safely grow around 8%, but the nominal repo rate must fall alongside a projected decline in inflation, argues Ashima Goyal, an external member of the Monetary Policy Committee.

The Reserve Bank of India has projected India's GDP growth at 7.2% in the current fiscal year. In the latest MPC minutes, Goyal flagged weak consumption and below-potential growth. If inflation continues to fall and expected inflation approaches the target with growth at 8%, it means the economy can sustain such growth rates without stoking inflation.

However, keeping the repo rate above equilibrium will not reduce food inflation, as it cannot directly affect food prices driven by supply-side factors. A positive real repo rate is adequate for maintaining the credibility of monetary policy and anchoring inflation expectations. Maintaining the current high repo rate could adversely affect demand and worsen supply-side constraints, leading to a potential economic slowdown.

Comment below your thoughts on the next expected moves of the Central Bank.