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Why RBI chose not to pivot to growth

Jun 08, 2023 08:47 PM IST

Inflation may be dipping but medium-term outlook is cloudy. Most global central banks are not cutting rates. Why we may be in for a long pause in policy rates

The monetary policy die was cast even before the Reserve Bank of India (RBI)’s June monetary policy committee (MPC) meeting began. Resilient growth and falling inflation did not leave much room to debate whether there was any scope to surprise the market. However, the markets were looking for a signal that the pause Governor Shaktikanta Das emphasised in April would transform into a pivot.

 The answer from MPC on Thursday was decisively against a pivot(MINT) PREMIUM
The answer from MPC on Thursday was decisively against a pivot(MINT)

The answer from MPC on Thursday was decisively against a pivot.

There are good reasons for RBI to not signal a shift in thinking. Globally, most major central banks are still in a rate-hike cycle, and while fears of financial instability escalated in April, upside inflation surprises and resilient economic data have kept global policymakers on a path of tightening and pushed back any reversal.

Domestically, RBI is now benefiting from its short but aggressive rate hiking cycle, with real rates turning positive. Still, the bulk of the disinflation seen in recent months was due to moderating food prices, not necessarily because of slowing growth. Global commodity prices have also eased, but the government has not allowed for a complete pass-through, choosing instead to replenish its revenues, which took a beating given the price spikes last year.

While the economy does benefit from the improving terms of trade, India’s strong domestic growth may not create conditions where RBI sees material weakening in pricing power. The pressure on producers to lower output costs will be less than it would have been had growth been materially weakening.

Hence, the question arises — Is there presently a need for monetary policy to shift gears and support domestic growth? So far, RBI has not flagged any particular risk of an economic slowdown and indicated Gross Domestic Product (GDP) growth to be around 6.5% in FY 2023-24, which by our estimates will be close to India’s trend GDP growth.

This also means that at current policy settings, the growth sacrifice associated with raising interest rates is around 65 basis points, according to RBI (as growth would slow from 7.2% to 6.5%). That does not appear very large in terms of maintaining broad macro stability through the prism of inflation. This is especially so when one looks back at RBI’s own guidance in earlier meetings, when it flagged that breaking the persistence of core inflation was essential to “strengthen the medium-term growth prospects”. Thus, it may be understood that RBI believes it is necessary to tame inflation to support growth, even if it entails short-term sacrifice.

Going ahead, what is the likely action plan for RBI? We think three factors will determine the timing of the central bank’s pivot — the inflation outlook for the next 12-24 months, growth momentum in an environment of a global slowdown, and signals of a turn in the global monetary policy cycle.

As an inflation-targeting central bank, RBI clearly indicated that it would want to watch for signs of sustained disinflation, with the headline inflation, ideally with core, nearing the medium-term target of 4%. Governor Das’s message — the inflation number just being within the tolerance band was not good enough — was clear and put the 4% target at the centre of policy decisions. Further, while inflation indeed came down in the past few months, the medium-term picture is cloudier. With improving corporate pricing power and some persistence in core inflation, price levels may still prove to be sticky. This may lead to headline inflation converging to core eventually. There is also the spectre of El Nino impacting the monsoon, and consequently food production and prices. More clarity on the spatial distribution of rainfall can only be gauged by July-August, before which it will be difficult for RBI to get clear signals on the inflationary front.

On growth, RBI seemed to have fewer concerns, given the resilience seen in most high-frequency indicators. That said, India will not be entirely insulated from headwinds arising from weak external demand: Already, these signs are evident in export growth contracting and industrial production slowing. Domestically too, tighter financial conditions from rate hikes are expected to temper aggregate demand as the transmission plays out more fully to lending rates.

Apart from domestic factors, RBI would also watch the choreography of systemically important central banks. While the global monetary cycle is converging to peak rates, the timing appears highly uncertain, especially with US economic data still strong. This has led markets to push out their expectations of a Fed rate cut beyond 2023, similar to the European Central Bank (ECB). Now, even though RBI does not have a specific interest differential in mind, it does watch global financial conditions, and with the Fed and ECB not cutting rates any time soon, it will likely see little reason to do so, lest India’s economy itself experiences a sharp slowdown. That might be a low-probability outcome, as things stand.

We think given the above factors, RBI will have a preference for maintaining its hard-won stability over growth. This should result in a prolonged pause in policy rates: Our base case is for MPC to cut rates only in the second quarter of calendar year 2024. Most central banks globally face the difficult prospect of addressing this growth-inflation trade-off, but we think the Indian economy is positioned relatively better to navigate these perilous waters, without a need to pivot, for now.

Rahul Bajoria is managing director and head of EM Asia (ex-China) Economics at Barclays, and Amruta Ghare is regional economist. The views expressed are personal

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