Opinion 3 reasons why the RBI has held interest rates steady

The risks remain

First, although inflation has been trending down, the battle is far from over. While consumer price inflation — the MPC’s primary target — fell within its target range of 2-6 per cent over the past two months, it is still some distance from the preferred figure of 4 per cent. The RBI expects consumer inflation at 5.4 per cent this fiscal, while our forecast is slightly higher at 5.5 per cent.

The good news is that core CPI inflation has been easing for the last five months. Core — stripped of volatile food and fuel components — is meant to give more durable signals on the inflation trajectory. At 4.3 per cent in October, the gauge was lower than the overall CPI inflation of 4.9 per cent. The decline in the prices of commodities offered relief, reducing pressure on firms to pass on higher input costs to consumers.

But food remains a significant risk. Critical food items such as cereals, pulses and spices have seen double-digit inflation throughout this fiscal. Not much respite seems in sight as an uneven monsoon has hampered agricultural prospects this year. The government’s first advance estimates peg kharif production 4.6 per cent lower on-fiscal. The ongoing rabi season may also be at risk due to lower water reservoir levels — at 78 per cent of last year’s level as of November 30.

Global food supplies face risks from El Niño, which is expected to persist till the first half of 2024 (as per the United States National Oceanic and Atmospheric Administration). Any unseasonal and extreme weather event will prevent the softening of elevated food inflation. While such supply shocks are beyond the RBI’s control, food constitutes 39 per cent of the average Indian consumer’s basket and persistent food price shocks can lead to generalised inflation pressure. That is the worry.

The West is still worried

Second, systemically important central banks such as the US Federal Reserve and the European Central Bank (ECB) have signalled higher-for-longer interest rates, which, too, influences monetary policy decisions, if peripherally. The Fed and ECB have stood pat in the past two months. But their policy rates are the highest since 2007. S&P Global doesn’t see any cuts by them before mid-2024.

These economies have also seen inflation ease, but core inflation remains above their comfort zones. Growth in the US has been surpassing expectations, with predictions of recession being replaced by a slowdown by next year. Against this backdrop, central banks are extending higher rates for longer, to avert another inflation surge. Central banks across emerging markets are evaluating the impact of high global interest rates. Indonesia even raised its policy rates in October in response to its weakening currency.

The impact on India of fast and furious rate hikes by the west has been manageable so far. Foreign portfolio investments have been hit by global volatility yet remain higher than last fiscal. The rupee’s depreciation remains less than last year, supported by the RBI’s forex interventions in times of volatility. India’s improving domestic and external fundamentals this fiscal year have also helped maintain investor interest. Yet, as high global rates continue next year, shocks could increase, on which the RBI cannot lower its guard.

Borrowers are still waiting

Third, the transmission of its past rate hike into lending rates remains incomplete. The RBI’s 250 basis points rate hikes between May 2022 and February 2023 have been transmitted in varying degrees across different financial market instruments. Not all bank lending and deposit rates have risen to this extent.

While keeping its ammunition dry, the RBI is using other measures to further its goals on inflation and financial stability. It is focused on maintaining liquidity tight enough to facilitate the transmission of its past rate hikes and has used macroprudential tools (read increasing risk weights) in segments where it smells risk.

The RBI has proactively been reducing excess liquidity from the banking system, which puts pressure on banks to raise their deposit and lending rates. In previous policies, it imposed an incremental cash reserve ratio (I-CRR), and announced open market sales of government securities to reduce liquidity. Systemic liquidity has turned mild deficit in the past two months. In this monetary policy, it said that it will remain nimble in liquidity management.

Despite rate increases, bank credit growth has sustained over 15 per cent this fiscal, unchanged from last year. Robust economic momentum and healthy bank balance sheets have been the drivers here.

On its part, the RBI has been keeping an eagle eye on the strong credit offtake in risky segments such as unsecured consumer credit. The other concern is high bank credit flow to non-banks. The RBI Governor flagged this during the FIBAC 2023 conference, saying the increasing interconnectedness between the two raises the possibility of stress contagion across the financial system.

To tackle this, the RBI is currently relying on regulatory measures such as increasing risk weights for lending to these segments. Higher risk-weights raise the capital requirement for lenders and thereby put upward pressure on lending rates for consumers.

While keeping the inflation forecast unchanged, the RBI lifted its growth forecast for this fiscal to 7 per cent from 6.5 per cent earlier. The positivity on the economy follows the latest gross domestic product growth of 7.6 per cent for the second quarter, much higher than the RBI’s estimate of 6.5 per cent. This implies that growth will slow to 6.3 per cent in the second half of this fiscal from 7.7 per cent in the first half.

Strong government spending consumption had a significant role in boosting GDP in the second quarter, which may continue in the remainder of the year. However, India’s export earnings are expected to be more of a drag in the second half as a slowdown in western advanced economies progresses. Domestically, too, rising interest rates will temper domestic demand. The recent moderation in PMI services hints at some moderation growth.

On balance, India will continue to be a growth outperformer among large economies this fiscal. Monetary policy this fiscal began with a pause on rates and stance and is set to end the same way. We expect rate cuts only in the first quarter of the next fiscal.

Joshi is Chief Economist and Tandon is Senior Economist, CRISIL Limited. Views are personal