The monetary policy review was largely around expected lines with both rates and stance kept unchanged with a majority of 4:2. That said, there were outlier expectations both on the dovish and hawkish side and from that standpoint it was not an entirely uneventful policy. As an example, given the recent rise in headline system liquidity and the softening in overnight rates, there was some expectation that RBI may announce some more direct measures to absorb liquidity. This is especially given the secondary market OMO bond sales that it has been doing for minor amounts over the past few weeks. In the event, apart from the usual commitment to remain nimble on liquidity management, the Governor didn’t make any further announcement. On the dovish side, a minority of market participants had hoped for a stance change to neutral, which got frustrated.
We turn now to some notable takeaways from the policy as well as the overall global context which has thrown up some interesting new developments lately.
Takeaways
A recent debate has emerged on whether RBI should look at inflation ex-food. The argument generally goes that monetary policy cannot affect food inflation and that the gap between food and non-food inflation has persisted thereby suggesting limited risk of pass through of food pressures into generalized inflation. Also, given rising frequency of weather vagaries, volatility in food inflation is becoming more the norm than the exception thereby keeping monetary policy almost always hostage to such developments, especially given our context of very high food weight in the overall CPI basket.
The Governor chose to directly weigh in on the debate, conclusively rejecting the idea that any notion of targeting inflation ex-food should be entertained. This is of no surprise, and any credible central banker should be expected to act the same way. The reasons he gave are as sound as they are well documented: 1> Food has about 46% weight in the basket, and with this high share food pressures cannot be ignored. 2> Public at large understands inflation more in terms of food inflation rather than other components. 3> High food inflation affects household inflation expectations which can in turn affect overall inflation via spill overs from pickup in wages and onward higher prices from firms in a scenario of strong aggregate demand 4> Such behavioral changes can then result in overall inflation becoming sticky, even after food inflation recedes.
The Governor noted that household inflation expectations have actually edged back up since November 2023 on the back of high food inflation. Indeed, the large volatility in food inflation is repeatedly coming in the way of RBI sighting enough conviction towards its 4% target. Given that a change in stance will signal a rise in willingness to cut the repo rate, this is also coming in the way of a stance change, even as it isn’t necessary for such a change to precede an actual rate cut. That said, there is enough reason to believe that we are edging closer to the RBI yielding for the following reasons:
1. The dispersion of inflation is too extreme to be sustainable, especially since a major contributor is the highly volatile, short cycle vegetable basket. Vegetables have a 6% weight but prices here are rising at 29% year on year. Meanwhile, CPI ex-vegetables has been averaging 3.5% for the past 4 months. Thus, there is every reason to expect this dynamic to get relieved at least somewhat in the not too distant future with consequent easing of concern with RBI. Cereal inflation, though nowhere as extreme as vegetables, has also been sticky around 8 – 9%, However, relief here may be forthcoming as well. As the Governor himself noted, monsoons have picked up, sowing is progressing well, buffer stocks are above norms, and global food prices have shown signs of easing. It is likely that RBI gets more comfort around these factors over the next couple of months or so.
2. There is currently enough comfort on the robustness of growth for RBI / MPC majority to focus exclusively on inflation, effectively the volatile food inflation. This is ‘easier’ to do since this focus really requires them to do nothing incrementally, at least from a monetary policy standpoint. To clarify, and just to illustrate the point better, had they been hiking still in order to demonstrate continued focus on inflation, then the burden of proof from growth would have been that much lower for them to change their actions. The burden is far higher now since continued focus on inflation equals continued inaction. It is unlikely then that growth becomes a near term reason for them to act. However, the combination of incremental developments on inflation (as discussed above) and growth may very well meet the criterion to at least change stance soon (which merely signals neutrality or a lower bar to cut in the future than is the case now). An initial small point on growth has already emerged: RBI has minorly nudged down Q1 FY 25 GDP growth forecast reflecting lower than anticipated corporate profitability, general government expenditure, and core industries output. There is a chance that the first and third of these reasons sustains and indeed accentuates reflecting global developments that we turn to next. Also, signs of some incremental credit growth slowdown is already manifesting, largely consistent with RBI endeavors. However, this can easily become more notable if global developments impact in some way demand for credit as well, especially from corporates.
Global Developments
The recent few days have seen a dramatic manifestation of a series of developments that have been ongoing for some time. US data has been slowing thereby moderating Fed rate hawkish expectations and triggering a refreshed no landing vs soft landing vs hard landing debate. Then the most recent jobs data showed a notable rise in the unemployment rate, thereby leaning the debate between soft and hard landing. The other important part of the story has been the recent Bank of Japan hike. A combination of these two, has led to repricing of relative rate expectations in these two large economies. The matter would be settled amicably here but for global financial positions getting mis-footed. A favorite so called carry trade has been to borrow in yen and invest elsewhere. With cost of yen borrowing being so low and with the currency continually depreciation till recently, such trades where being handsomely rewarded. However, these were disrupted basis developments mentioned above and soon gathered a life of their own with further unwinding of financial positions, thereby amplifying relative market movements. Thus, there may be an element of noise in the current market pricing of almost everything. That said, there are nevertheless important takeaways from ongoing global developments.
1. The US slowdown seems real and the prognosis is not just basis one data point. Apart from economic data, a host of companies associated with leisure, travel, tourism, food etc seem to be confirming the point that the economically lower percentiles of consumers may be paring back. If left to run further, this becomes self-enforcing as companies scale back production and employment, and further feed the slowdown. Indeed, this is precisely the perspective we will use to evaluate the recent discussions with respect to the so-called Sahm Rule. The rule signals the start of a recession when the three month moving average of the national unemployment rate rises by 0.50% or more relative to the minimum of the three month averages from the previous 12 months. This has been triggered in the US and the debate goes whether this signals the start of a US recession or whether things may be different this time. While the issue of recession will only get settled with the benefit of actual economic data, the development is indisputably one of concern: unemployment rate on average has risen meaningfully since its bottom and one cannot rule out that this can take on a momentum. This is especially true since, as referred to above, there are enough signs of some sections of consumers pulling back which may soon manifest in similar behavior from companies. Thus, the Fed will soon have to swing in action, especially as given the high level of cycle rate in the US versus what can be deemed long term neutral, the burden of proof required from growth data is quite modest and in fact most likely has already been met. Indeed, the current debate is whether the Fed is already behind the curve in cutting rates.
2. China economic data has disappointed lately triggering fresh monetary easing. Metal prices have been under pressure for some time, and oil has been unable to build on gains despite elevated geo-political risks. Meanwhile, German manufacturing has also been struggling for a while. Thus, growth concerns are genuine in large parts of the world.
3. While too soon to tell yet, recent global financial market developments (lower equities, higher credit spreads) may well constitute financial conditions tightening incrementally. This in turn will also feed into real economy growth.
Conclusion
The policy today kept focus on the volatile food inflation with RBI / MPC drawing comfort from the ongoing strength in growth. This is especially possible since continued focus implies continued inaction with an underlying context that policy rate in India is not very far from what would be deemed as long term neutral rate. Thus, there is very little chance of a ‘policy error’ in the case of RBI, much unlike its Western world counterparts. That said, inflation composition is heavily skewed and the volatile vegetable component may (hopefully) soon provide some relief. While RBI’s growth forecast is strong, risks abound especially from global factors where large swathes of the world are distinctly slowing. All told, and for the reasons analysed here, we think the bar to communicate lesser probability of continued inaction may be met relatively soon. We will look for a stance change in the October policy followed by a rate cut in December. That said, a change in stance doesn’t need to necessarily precede the actual first cut.
We are not looking for more than 75 bps cuts in this cycle, unless the Western world heads towards a more severe than currently expected landing. However, as we have highlighted multiple times before, Indian bonds look to us to be a structural trade basis a very favorable demand – supply environment especially for government bonds over the next few years. The current juncture is particularly noteworthy since it reflects the confluence of bullish cyclical factors with the more enduring structural story, in our view. Investors should continue to focus on plugging re-investment risk via adequate duration selection on incremental investments.
Source: RBI and Bandhan internal research
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