Opinion
Neutral stance gives RBI freedom for managing liquidity
Summary
- There is a change in the RBI governor’s statement from the last policy with focus increasingly shifting to balancing growth and inflation rather than being ‘actively disinflationary’.
The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) unanimously voted for a change in stance to neutral from withdrawal of accommodation while one member dissented on the rate action in favour of a rate cut. There is a significant change in the RBI governor’s statement from the last policy with focus increasingly shifting to balancing growth and inflation rather than being ‘actively disinflationary’. The neutral stance gives RBI more degrees of freedom for managing liquidity and thus transmission of policy rates into broader interest rates.
The change in stance is due to both global and domestic factors. Globally, across developed and emerging markets, central banks are now easing policy rates and injecting liquidity driven by changing domestic growth and inflation dynamics even as there are a few outliers (Japan, Brazil and Russia). While commodity prices have gone up recently after stimulus announcement by China, the slower world growth is most visible in oil prices which have been moving lower due to weak demand. Even as geo-political risks have flared up, prices have not sustained above $80 per barrel.
Though there were a few data prints on the domestic side that were underwhelming and point towards growth concerns, RBI has chosen to retain its growth estimate for FY25. The Q1 growth was lower than RBI’s estimate since government spending was lower. Even Q2 growth would be impacted by above normal rainfall seen in the second half of the monsoon which has driven power demand lower. While RBI has revised H1 growth lower to 6.9% from 7.1% earlier, it has revised H2 growth higher to 7.4% from 7.3% and hence managed to retain the projection at 7.2%. So, there is a good chance that by December RBI might have to lower the projection and the option to cut rates in December comes very much in to play.
Another factor that has worked is the positive outlook for medium-term on food inflation because of above normal monsoon. This is visible in RBI’s medium-term forecasts. RBI’s March 2025 and 2026 forecasts are benign at 4.2% and 4.1%. Apart from expected deceleration in food prices, another factor driving these forecasts is assumption of oil prices now at $80 per barrel as against $85 per barrel earlier.
The MPC has now opened the door for reducing policy rates to ensure real rates are not high enough to induce any growth sacrifice. How deep can the rate cuts be in India? Given the current projections for financial year ending 2025 and 2026, real rates are far above RBI’s neutral rate range of 1.4-1.9%. Assuming growth remains above 7% (7.2% in FY25 and 7.1% in FY26) as projected by RBI, higher end of the neutral rate range would call for a 50bps rate cut in the cycle. However, if the global growth backdrop is weaker and India’s domestic growth is also lower then, the neutral rate should be at least in the mid-point of the range. This could entail a 75bps rate cut in the cycle.
The next big question is on the timing of rate cut. Every policy is live for a rate cut with December odds at more than 50%. As we have argued earlier, potential weaker domestic growth and medium term inflation hugging the 4% target rate along with further rate cuts by global central banks makes the case strong for rate cut in December. The effect of today’s action on the policy stance is possibly much more positive for liquidity. In case of withdrawal of accommodation, RBI had been keeping a tighter leash on liquidity while in the case of neutral stance, RBI could afford the liquidity conditions to be far more supportive of growth. This, in turn, means swiftness to respond to liquidity deficits as well and a higher tolerance for having overnight rates staying between the Standing Deposit Facility (SDF) and the repo rate.
What can happen to change the above trajectory? The most important change could be geo-politics in case the Middle East conflict and Ukraine war escalate. This would be negative for markets and would drive oil prices higher despite weak demand in China. Second, if China follows through with a large fiscal stimulus, commodity prices may go up and foreign portfolio investor (FPI) outflows may be visible in India as is the case in the last few days. Last but not the least, US presidential elections and economic policy would have an impact on global growth and markets. The MPC has positioned itself with a neutral stance which gives it flexibility and optionality in the words of the RBI Governor to move as the growth inflation mix changes.
B. Prasanna is head-Treasury and Sameer Narang is head- Economic Research Group at ICICI Bank.
