Hawkish pause. That is how the market seems to read the Reserve Bank of India's monetary policy committee decision to keep the repo rate on hold at 6.50 per cent. The third straight pause in the benchmark rate at which the central bank lends money to commercial banks comes at a time a spike in vegetable prices has raised near-term inflation concerns, even as the real GDP growth for the year is expected to remain fairly strong, compared to the slowdown in many advanced economies.
Among the key decisions taken by the MPC on Thursday, the repo rate was left unchanged at 6.50 per cent. At the same time, the MPC decided by a majority of five out of six members to remain focused on "withdrawal of accommodation" to ensure that inflation "progressively aligns with the target," while supporting growth.
The GDP growth for the current financial year was retained at 6.5 per cent. However, the CPI (consumer price index) inflation forecast for 2023-24 was raised to 5.4 per cent, from the previously forecast 5.1 per cent. More importantly, the CPI inflation projection for July-September has been raised sharply to 6.2 per cent, versus 5.2 per cent projected in the last MPC meeting, in the wake of the surge in vegetable prices.
The RBI has a target to bring inflation down to 4 per cent, plus or minus 2 per cent. Essentially, the RBI would be comfortable keeping inflation in the 2-6 per cent range. But, now Das feels that may not be enough.
"Bringing headline inflation within the tolerance band is not enough; we need to remain firmly focused on aligning inflation to the target of 4.0 per cent," he said on Thursday.
The key concern emanates from the recent surge in prices of vegetables like tomatoes, while pulses prices are also on the up. The hope is that as the supply improves over the next few months, prices should cool. But, then there are also uncertainties on how the monsoon will unfold in the months ahead and the impact if any of El Nino in August and September. Das further said uncertainties on domestic food price also remain due to sudden weather events.
Against this backdrop, how inflation pans out over the next few months will determine the MPC's moves. Clearly, indications are that interest rates are likely to stay on the higher side for a longer period and any rate cut hopes, perhaps towards the end of the year, are diminishing fast.
"Today's statement had a hawkish tilt with inflation projection revised upwards and we therefore expect no rate cut in FY24," said Jahnavi Prabhakar, economist at Bank of Baroda.
The earliest possibility of a rate cut has now shifted to the first quarter of FY25, with the likelihood of a possible rate hike also on the table if inflation surges past 6 per cent on a continuous basis, she said.
Achala Jethmalani, economist at RBL Bank, too feels the MPC decision should be seen as a "hawkish pause."
"Upward revision in inflation forecasts while watching any persistence of idiosyncratic price spikes, strengthens the case of higher for longer, a theme that is playing out globally too. As India CPI inflation starts tapering-off in the second half of FY24, we expect the repo rate to remain unchanged at 6.50 per cent. Any price shocks could alter expectations," said Jethmalani.
What also surprised the market was the announcement of an incremental cash reserve ratio, aimed to mop up the additional liquidity that is there in the system due to return of the Rs 2,000 denomination currency notes to the banking system.
With effect from the fortnight beginning August 12, 2023, scheduled banks will have to maintain an incremental cash reserve ratio (ICRR) of 10 per cent on the increase in their net demand and time liabilities (NDTL) between May 19, 2023 and July 28, 2023.
Governor Das said this is a temporary measure and will be reviewed on September 8, 2023 or earlier with a view to returning the impounded funds to the banking system ahead of the festival season. However, this move is akin to monetary tightening in the short term, even as the cash reserve ratio (CRR) itself was left unchanged, say economists.
"The message from the policy was clearly hawkish in response to the rising inflationary risks. This was reflected in both the significant upward revision in RBI's inflation forecast and the decision to introduce 10 per cent incremental CRR for banks," said Abheek Barua, chief economist at HDFC Bank.
The total liquidity in the system stood close to Rs 3.5 lakh crore, with the LAF (liquidity adjustment facility) balance at Rs 2 lakh crore as of August 8, according HDFC Bank economists. Tighter liquidity conditions could imply some upward pressure on both credit and deposit rates as transmission of past rate hikes improves, said Barua.
The RBI could remain on hold through the current financial year and a rate cut is not likely before the first quarter of 2024-25, he added.
The imposition of ICRR would imply a temporary liquidity depletion of around Rs 99,600 crore to Rs 1.15 lakh crore, said Madhavi Arora, lead economist at Emkay Global Financial Services. It could lead to some interest loss for banks as banks were parking the short-term liquidity into short-term personal loans and money markets, she said.
"The immediate impact of RBI absorbing liquidity via ICRR will be mild hardening of money market rates for borrowers including non-banking finance companies/ corporates, while for banks as well, there will be slight impact on their net interest margins (3-4 basis points)," Arora stated.
With the inflation surge largely confined to food, the RBI justifiably refrained from any rate action at the moment, but another rate hike in the coming months cannot be ruled out, feels Siddhartha Sanyal, chief economist and head of research at Bandhan Bank.
"In that context, the MPC meeting in early October remains a live one. Apart from India's inflation dynamics, action and guidance of the US Federal Reserve in September will play a crucial role in influencing global policy rate cycle, including that of India in October," said Sanyal.
The Fed raised its Federal Funds Rate again in July to a new range of 5.25-5.5 per cent and officials have said further rate hikes may be needed to bring down inflation. The Bank of England also raised interest rates earlier this month.