Cooling inflation opens door for RBI to cut interest rate but a falling rupee creates new challenges

Overall, the food inflation has eased to around 8.4 per cent from 9.04 per cent, while core inflation, which excludes food and energy, remains low at 3.6 per cent

RBI bomb threat (FILE) Reserve Bank of India logo inside RBI headquarters in Mumbai, India | Reuters

The Reserve Bank of India's monetary policy committee will meet in February. It will be the first MPC meeting of the new RBI Governor Sanjay Malhotra, who took over from Shaktikanta Das in December. Under Das's leadership, the RBI MPC held the policy repo rate unchanged at 6.5 per cent for 11 consecutive times. For much of that time, the key worry was taming a food price driven CPI (consumer price index) inflation.

The latest data shows CPI inflation cooled to a 5.22 per cent in December, a four-month low, from 5.48 per cent in November. The key reason the inflation has stayed above RBI's 4 per cent target has been volatile food prices, especially vegetables. That pressure seems to be easing. In December vegetable prices rose 26.6 per cent, slower than the 29.33 per cent in November and significantly lower than the over 42 per cent rise in October.

Overall, the food inflation has eased to around 8.4 per cent from 9.04 per cent, while core inflation, which excludes food and energy, remains low at 3.6 per cent.

This fall in CPI inflation certainly opens the doors for the central bank to review interest rates and perhaps initiate a cut in the rate at which it lends money to central banks come February. It had already cut the Cash Reserve Ratio that banks need to maintain by 50 basis points from 4.5 per cent to 4 per cent in December.

The fact that India's economy has slowed, the first advance estimates released recently projected the GDP growth for 2024-25 at 6.4 per cent, a four-year low, will add in to the pressure on the central bank to start bringing down high interest rates, which will ease lending costs and in turn aid a pick-up in consumption and corporate borrowing.

"Expected moderation in inflation in coming months, will allow the MPC to consider a policy rate cut amid slowing growth," said Rajani Sinha, chief economist at CAREEdge Ratings. The ratings agency expects the headline inflation to fall below 5 per cent by the fourth quarter of the current financial year ending March 2025, as food inflation moderates, and this would create an opportunity for the MPC to consider a 25 bps reduction in the repo rate in February, Sinha said.

However, the RBI will also be carefully watching the continued depreciation in the rupee versus the US dollar. Amid, uncertainties around how incoming US President Donald Trump's trade policies play out, there has been a massive pull out of foreign institutional money from equity markets, which couple with a strengthening dollar has put a sustained pressure on the rupee; it hit a record low past the 86.5 mark on Monday.

The fresh set of sanctions that the Biden administration in the US has imposed on Russian exports led to crude oil price rising to a four-month high. This rise, if it were to sustain, could well add on the inflationary pressures and is certainly not a good thing for countries like India, which are huge importers of crude.

"The domestic growth and inflation outlook warrant easing financial conditions, however, external factors are increasing pressure on the currency and at the margin tightening financial conditions. Against this external backdrop, we see the risk of a delay in monetary easing," said Upasana Chachra, chief economist at Morgan Stanley.

In its base case, Morgan Stanley still expects the central bank to cut rate in the February MPC meeting.

But, "relentless dollar strength and an increase in long-end US yields could potentially constrain the RBI's ability to ease financial conditions as it increases the risk of higher inflation, delaying a potential rate easing," said Chachra.

According to Sonal Varma, Nomura's chief economist for India and Asia ex-Japan, their data suggests headline is tracking 4.5 per cent in January, and vegetable prices are further seen cooling. Nomura expects CPI to average 4.2 per cent in 2025-26 financial year.

The GDP growth in July-September was below RBI's projections and Nomura sees October-December quarter GDP growth will also come in below the central bank's expectations. However, currency depreciation pressures are creating new challenges.

"Domestic liquidity has tightened significantly from the RBI’s forex interventions, but allowing the currency to depreciate will add to imported inflation risks. In the end, we expect the RBI to follow a more orthodox flexible inflation-targeting monetary policy framework. If inflation is near target, despite currency weakness, and growth below trend, then we would expect the MPC to support growth," said Varma.

Nomura is also expecting a 25 bps rate cut in February with a total reduction of around 100 bps (1 per cent) in calendar year 2025. However, for policy transmission to happen, there will have to be more durable means of liquidity injection to reverse the tightening already done, Varma added.

Economists at HSBC are expecting two 25 bps cuts in the repo rate in the first half of 2025 taking the repo rate to 6 per cent. They too note vegetable prices have fallen in the 12-27 per cent range in the first ten days of January and therefore headline inflation for the month is likely to be around 4.5 per cent.

"With core inflation range bound, and food inflation expected to come off, space for monetary policy easing is likely to open up, particularly as and when forex volatility eases," they said.

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