Category: Monetary Policy Review

The Reserve Bank of India (RBI) reduced policy rates by 25bps, a decision unanimously supported by all Monetary Policy Committee (MPC) members, while maintaining a neutral policy stance, also backed by the committee. FY26 GDP growth is projected at 6.7%, with CPI inflation estimated at 4.2%. The RBI highlighted rising global risks leading to capital outflows and a weakening USD-INR exchange rate. Future policy actions will be data-driven to balance inflation and growth dynamics, with liquidity conditions managed to ensure adequate system liquidity.

Key Takeaways from RBI’s Statement:

The MPC acknowledged that inflation has moderated, supported by a favourable food inflation outlook and the continued transmission of past monetary policy actions. Headline inflation is expected to ease further in FY26. However, growth has slowed significantly compared to the previous year’s trend. These dynamics provide room for the MPC to focus on stimulating growth while ensuring inflation remains aligned with the target. Consequently, the MPC decided to lower the policy repo rate by 25bps to 6.25% while maintaining a neutral stance to retain flexibility in responding to evolving macroeconomic conditions.

Growth and Inflation Outlook:

FY26 Growth Estimated at 6.7%

The first advanced estimate places FY25 growth at 6.4%, driven by a recovery in private consumption. Growth is being supported by the service sector and improvements in agriculture, while sluggish industrial growth remains a drag. Looking ahead, strong rabi forecasts and an anticipated industrial rebound should strengthen economic expansion in FY26. Household spending is expected to remain robust, aided by income tax relief in the Union Budget. Fixed investment is set to pick up, supported by higher capacity utilization, strong corporate and financial sector balance sheets, and continued government-led capital expenditure.

However, risks remain, including geopolitical tensions, protectionist trade policies, fluctuations in global commodity prices, and financial market uncertainties. Given these factors, FY26 real GDP growth is projected at 6.7%, with quarterly estimates as follows:

• Q1: 6.7%
• Q2: 7.0%
• Q3: 6.5%
• Q4: 6.5%

Global Economy Remains Stable

While global growth remains below its historical average, high-frequency data suggests resilience, supported by continued expansion in global trade. Key risks include geopolitical uncertainties, slower disinflation, and policy unpredictability. Additionally, a strong US dollar continues to pressure emerging market currencies, increasing financial market volatility.

FY26 Inflation Expected at 4.2%

The inflation trajectory will depend on several factors:

1. Food Inflation: Expected to soften, provided there are no supply-side shocks, supported by good kharif production, easing vegetable prices in winter, and positive rabi crop prospects.
2. Core Inflation: Expected to remain moderate.
3. Global Uncertainty: Continued financial market volatility and fluctuations in energy prices remain concerns.
4. Weather Risks: Adverse climatic events pose upside risks to inflation.

Taking these factors into account, the CPI estimate for FY25 is maintained at 4.8%, with Q4 revised to 4.4% (-10bps). The FY26 CPI projection stands at 4.2%, with quarterly estimates as follows:

• Q1: 4.5%
• Q2: 4.0%
• Q3: 3.8%
• Q4: 4.2%

Liquidity and Financial Market Measures:

• Forward Contracts in Government Securities: This initiative will help long-term investors, such as insurance funds, manage interest rate risk across cycles and enable efficient pricing of bond-backed derivatives.
• Expanded Access to the RBI Electronic Trading Platform: SEBI-registered non-bank brokers will now be allowed to participate in secondary market transactions for government securities.
• Market Trading and Settlement Review: The RBI will conduct a comprehensive review of trading and settlement timings for financial markets under its regulation.

System Liquidity in Deficit:

Liquidity turned negative in December and January, driven by factors such as advance tax payments, capital outflows, forex operations, and a notable increase in currency circulation. India’s foreign exchange reserves have eased from record highs, standing at $631 billion as of January 31, 2025.

Cybersecurity and Payment Systems:

• New ‘bank.in’ Domain: A dedicated domain for Indian banks aims to enhance cybersecurity and trust in digital banking and payment services. A ‘fin.in’ domain is also planned for non-bank entities in the future.
• Additional Factor of Authentication (AFA) for Online International Transactions: Strengthening security for international card-not-present (online) transactions by implementing AFA for added protection.

Our Analysis:

The repo rate cut and RBI’s commentary align with expectations. The new governor emphasized the importance of the existing flexible inflation-targeting framework while signaling potential refinements in line with evolving data and conditions. His first policy statement suggests continuity with the previous regime and regulatory approach.

We anticipate that future rate cuts will remain data-dependent, influenced by inflation trends, global developments, asset prices, and domestic growth. Liquidity support measures are a structural positive for the economy. Our FY26 GVA estimate aligns with RBI’s projection, while our inflation outlook is slightly higher.

In its December 2024 policy review, the US Federal Reserve substantially revised its inflation projections for calendar year 2025. The Personal Consumption Expenditure (PCE) inflation forecast was raised by 40 basis points (bps) to 2.5%, reflecting the recent elevated inflationary pressures and the anticipated effects of Donald Trump’s proposed tariff policies. Furthermore, the Federal Reserve’s updated dot plot signaled fewer rate cuts in 2025, reducing expectations from three cuts to two. The median projection for the Federal Funds Rate for CY25 now stands at 3.9%, reflecting an upward revision of 40 bps.

The implications for India could include a delay in interest rate cuts. This is due to the lowest interest rate spread over the US in recent history and the inflationary risks posed by Trump’s tariff policies. Even with an expected moderation in food prices, overall inflation in India may remain elevated, supported by a resurgence in growth in H2 FY25. The latter could be driven by the tapering of election-related uncertainties, weather-related disruptions, and the positive impact of a 50-bps CRR cut by the Reserve Bank of India (RBI). A strong flash Purchasing Managers’ Index (PMI) reading for December 2024 at 60.7 suggests that the growth recovery in H2 FY25 has already begun.

US Fed Maintains Optimistic Growth Outlook Amid Rising Risks

Despite the evolving challenges, the Federal Reserve remains optimistic about the US growth trajectory, reflected in an upward revision of the GDP growth forecast for CY25 by 10 bps to 2.1%. However, the Fed’s policy statement was notably silent on critical risks posed by rising twin deficits.

• Current Account Deficit (CAD): The CAD surged to 4.2% of GDP in Q3 2024.
• Fiscal Deficit: The fiscal deficit climbed to $1.8 trillion (6.4% of GDP) in 2024.

Additionally, while the labor market continues to exhibit a gradual cooling, with the unemployment rate edging up to 4.2%, these structural imbalances pose longer-term concerns.

Key Risks to the US Economy

Several risks threaten the US economic outlook in 2025, including:

1. Rising Twin Deficits:
   • The widening CAD (4.2% of GDP) and fiscal deficit (6.4% of GDP) are compounding inflationary pressures and reducing fiscal maneuverability.
2. Inflation and Policy Uncertainty:
   • Revised inflation projections and the potential inflationary impact of Trump’s tariff and mass deportation policies add to macroeconomic risks. The effects of these policies on growth and the labor market remain uncertain.
3. Federal Budget Cuts:
   • Recommendations from the D.O.G.E. committee to reduce federal spending could adversely impact GDP growth and federal employment prospects in 2025.
4. Narrow Growth Margin:
   • While the US economy benefits from a slowing yet stable growth outlook, the risks of policy missteps are rising, leaving “very little margin for error.”

These factors collectively underscore the precarious balancing act for US policymakers, with potential spillover effects for global economies, including India. The interplay between growth, inflation, and fiscal dynamics will be critical to watch in the year ahead.

Key points from the press conference:

– Future decisions will be made on a meeting-by-meeting basis, relying on incoming data.

– The initial 50bps cut reflects confidence that inflation is trending toward 2%, though this does not suggest similarly aggressive rate actions will continue.

– The labour market will be closely monitored, as the current cut aims to maintain its strength.

– No recession indicators are evident at this time.

Changes in economic forecasts compared to June’s projections:

– GDP: Growth for 2024 was lowered to 2.1% (-10bps), with 2025 and 2026 growth unchanged at 2%, and 2027 growth projected at 2%.

– Unemployment rate: Revised higher to 4.4% (+40bps) in 2024, 4.4% (+20bps) in 2025, and 4.3% (+20bps) in 2026. The 2027 rate is projected at 4.2%.

– PCE inflation: Lowered to 2.3% (-30bps) for 2024, 2.1% (-20bps) for 2025, with the 2026 forecast unchanged at 2% and 2027 also at 2%.

– Core PCE inflation: Reduced to 2.6% (-20bps) for 2024, 2.2% (-10bps) for 2025, remaining at 2% for 2026 and 2027.

– Federal funds rate: Expected to decline to 4.4% (-70bps) in 2024, 3.4% (-70bps) in 2025, and 2.9% in both 2026 (-20bps) and 2027.

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The Federal Reserve has joined the easing cycle by reducing interest rates by 50 basis points (bps) to a range of 4.75%-5%. Only one committee member dissented, favouring a smaller 25bps cut. The Fed’s rate is now expected to fall to 4.4% by the end of the year, signalling an additional 50bps cut in 2024 and a further 100bps reduction in 2025. Headline inflation projections for 2024 and 2025 have been revised lower by 30bps and 20bps, respectively, while the 2024 growth forecast was reduced by 10bps to 2.1%, and the estimates for 2025 and 2026 were kept unchanged at 2%. These quicker rate cuts are expected to benefit both the economy and equities.

The accompanying statement reflected changes supporting this rate action. On inflation, the Fed noted that it has “gained greater confidence that inflation is moving sustainably toward 2%,” and that it now “judges the risks to its employment and inflation goals to be roughly balanced.” Additionally, the statement introduced new language, expressing a “strong commitment to supporting maximum employment.”

Key points from the press conference:

– Future decisions will be made on a meeting-by-meeting basis, relying on incoming data.

– The initial 50bps cut reflects confidence that inflation is trending toward 2%, though this does not suggest similarly aggressive rate actions will continue.

– The labour market will be closely monitored, as the current cut aims to maintain its strength.

– No recession indicators are evident at this time.

Changes in economic forecasts compared to June’s projections:

– GDP: Growth for 2024 was lowered to 2.1% (-10bps), with 2025 and 2026 growth unchanged at 2%, and 2027 growth projected at 2%.

– Unemployment rate: Revised higher to 4.4% (+40bps) in 2024, 4.4% (+20bps) in 2025, and 4.3% (+20bps) in 2026. The 2027 rate is projected at 4.2%.

– PCE inflation: Lowered to 2.3% (-30bps) for 2024, 2.1% (-20bps) for 2025, with the 2026 forecast unchanged at 2% and 2027 also at 2%.

– Core PCE inflation: Reduced to 2.6% (-20bps) for 2024, 2.2% (-10bps) for 2025, remaining at 2% for 2026 and 2027.

– Federal funds rate: Expected to decline to 4.4% (-70bps) in 2024, 3.4% (-70bps) in 2025, and 2.9% in both 2026 (-20bps) and 2027.

At the June 2024 meeting, the RBI Monetary Policy Committee (MPC) decided to maintain the repo rate at 6.5%. The policy stance also remained unchanged to ensure the anchoring of inflation expectations and fuller policy transmission. The monetary policy continues to be disinflationary as the MPC remains committed to aligning inflation with the 4% target on a durable basis.

The RBI Governor emphasized that food prices warrant close monitoring, and the MPC remains vigilant to the spillover risks to headline inflation from food. The MPC statement also mentioned that the rising incidence of adverse climate events creates considerable uncertainty regarding the food inflation trajectory. The Governor clarified that while the RBI considers the impact of monetary policy in advanced economies on Indian markets, its actions are primarily determined by domestic growth-inflation conditions and the outlook.

The RBI maintained the CPI forecast for FY25 at 4.5% YoY, with quarterly projections also remaining unchanged since the last policy. Food inflation pressures are expected to ease with a normal monsoon. However, input cost pressures due to the firming up of non-energy commodities and volatile crude oil prices pose upside risks to inflation.

The RBI raised the FY25 GDP growth forecast to 7.2% YoY from 7% in the April 2024 policy. An ‘above normal’ monsoon, as forecasted by IMD, bodes well for agriculture and rural demand. Investment activity is likely to remain on track, supported by high capacity utilization, healthy balance sheets of banks and corporates, the government’s continued focus on infrastructure spending, and optimism in business sentiments. However, headwinds from geopolitical tensions, volatility in international commodity prices, and geoeconomic fragmentation pose risks to the outlook.

We anticipate a shallow rate-cut cycle of 50-75 bps in FY25. The current growth-inflation dynamics favor shifting to a neutral policy stance in the August 2024 meeting. A normal or above-normal monsoon is expected to ease food inflation. Meanwhile, a slowdown in private consumption may impact growth and potentially undermine the revival in private capital expenditure. Adopting a neutral policy stance will allow the RBI to respond swiftly with a rate cut if warranted by the data.

With the Federal Reserve maintaining its expected stance, the focus turned to Chair Powell’s press conference. Given the recent disappointing progress in curbing inflation, the Committee will need more time than anticipated to be confident that inflation is steadily returning to target and that rate cuts are warranted.

Simultaneously, Powell played down the likelihood of further rate hikes and emphasized that policy remains tight. He cited a slowdown in labor demand and softness in interest-sensitive spending, particularly in housing and capital investment, as consequences of the tight policy. Powell outlined three probable scenarios, none of which included rate hikes: (1) persistent inflation = no cuts, (2) declining inflation = cut, (3) weakened labor market = cut. The USD weakened slightly, and USTs saw a bull steepening as the markets interpreted the press conference as less hawkish. However, equities experienced a downturn.

While Powell evidently isn’t satisfied with the current inflation situation, he seems to view inflation below 3% as not significantly deviating from the 2% target. He didn’t oppose a question hinting at a strategy of opportunistic disinflation akin to the 1990s, a concept previously suggested when advocating for no rate cuts earlier this year.

The policy direction is unfolding as anticipated in early 2024. There’s a suggestion to reconsider blind faith in central banks’ guidance post-pandemic, advocating for no rate cuts by the Fed (and consequently the RBI).

Relying solely on the Fed’s statements, which have been more volatile since the pandemic, could lead to investment strategy mistakes. This implies that drastic shifts (like rate hikes) may also require careful monitoring. The Fed’s rapid reversal from its March guidance on rate cuts in less than two weeks underscores this point. The potential misjudgment by policymakers regarding the transience or permanence of inflation post-Covid stems from macro models being based on past decade-long trends, while new structural changes are yet to be incorporated.

The absence of rate cuts by the Fed in 2024, followed by a shallow rate-cutting cycle, is becoming a reality as they struggle to achieve the final stretch of disinflation. This trend is affecting EM central banks, including the RBI. However, unless accompanied by immediate negative growth shocks, we don’t anticipate a collapse in EM risk assets and believe that a selective investment approach will fare relatively well for Indian assets.

Nevertheless, it’s important to recognize that significant divergence from Asia in both FX and rates may not be beneficial or desired by Indian policymakers, especially given the changing geopolitical landscape and economic models worldwide, necessitating agility from India as well.

During the February 2024 meeting, the RBI Monetary Policy Committee (MPC) opted to keep the repo rate steady at 6.5% and maintained its existing policy stance, which remains geared towards actively reducing inflation to ensure that headline inflation aligns with the 4% target over the long term. The decision to maintain the stance unchanged stems from incomplete transmission of rate increases to the credit market.

The RBI Governor highlighted ongoing uncertainties in food prices that continue to impact the trajectory of headline inflation. The MPC will vigilantly monitor any indications of widespread food price pressures that could undermine progress in easing core inflation. Additionally, the Governor acknowledged that liquidity conditions are influenced by external factors, such as high government balances, and the Reserve Bank intends to utilize an appropriate mix of tools to manage both short-term and lasting liquidity.

The RBI’s projections for fiscal year 2025 anticipate inflation at 4.5% year-on-year, while retaining the forecast for fiscal year 2024 at 5.4%. Favorable rabi sowing and adjustments in seasonal vegetable prices bode well for the inflation outlook. However, risks to this trajectory exist due to adverse weather conditions and disruptions in the supply chain arising from geopolitical tensions.

Expectations for real GDP growth in fiscal year 2025 are set at 7% year-on-year, with household consumption expected to strengthen. The outlook for fixed investment appears promising due to an upswing in private capital expenditure, improved business sentiment, strong financial positions of banks and corporations, and sustained government focus on capital expenditure. Nevertheless, the growth forecast faces challenges from geopolitical tensions, volatile financial markets, and economic fragmentation.

We anticipate the RBI to maintain its current stance at least until the June 2024 policy review. Monitoring the Rabi season production and IMD monsoon forecasts for 2024 will be crucial in assessing the trajectory of food inflation. Given the confidence in GDP growth, monetary policy will continue to prioritize achieving the inflation target. The RBI is also expected to keep liquidity close to neutral levels to mitigate risks to financial stability and inflation associated with excess liquidity, and to align overnight rates with the repo rate.