Keeping Vigil: Update on RBI Monetary Policy, August 2024

Rate Action

The Monetary Policy Committee today (August 8, 2024) voted 4-2 to keep the policy repo rate unchanged at 6.5%. They retained their stance at ‘withdrawal of accommodation’. The policy was in line with market expectations.

Forward Guidance

Given the recent global market volatility due to concerns of a sharper slowdown in the US and the ongoing unwinding of the Yen Carry Trade, a section of market participants was expecting a moderately dovish shift in the forward guidance of the policy.

However, the RBI largely maintained the continuity of its June policy with focus on maintaining a disinflationary stance in the backdrop of a comfortable domestic growth outlook.

The MPC noted the following:

“The MPC expects domestic growth to hold up on the strength of investment demand, steady urban consumption and rising rural consumption. Risks from volatile and elevated food prices remain high, which may adversely impact inflation expectations and result in spillovers to core inflation. Accordingly, the MPC decided to remain watchful on how these forces play out, going forward. The MPC reiterates the need to continue with the disinflationary stance, until a durable alignment of the headline CPI inflation with the target is achieved”.

Below are key RBI estimates on the evolution of growth/inflation trajectory into the next year compared to their previous forecasts:

* Source: RBI, A- Actual

Assessment of Inflation

The RBI increased its inflation forecast for Q2FY25 and Q3FY25 due to higher-than-expected food (vegetable) inflation.

However, the annual inflation projection remains unchanged as RBI expects a favourable impact of the progress in Monsoon and pick up in Kharif sowing on food prices in the second half of the fiscal year. While RBI acknowledged that food inflation should decline, it chose to remain watchful on spillovers of historically high and volatile food inflation to inflation expectations and core. The MPC noted that while it may look through a transitory high food inflation, it must be on guard against the current persistently high food inflation.

Given the unusual volatility in food prices, the RBI has been rightfully cautious, and it will be better off waiting for stability in inflationary trends to prevent any about-face (as we have seen in the case of many global central banks) and preserve its strong policy credibility.

Assessment of Growth

Q1FY25 growth estimate was revised to 7.1% from the 7.3% June policy estimate. The downward revision was due to a slowdown in private manufacturing companies’ profit growth and a contraction in Government expenditure.

The RBI retained its FY2025 real GDP growth forecast on expectations of improved rural demand due to a healthy Monsoon and a steady urban demand. It continued to expect growth in investment activity on high-capacity utilisation, healthy balance sheets of banks and corporates, the Government’s continued thrust on infrastructure spending and optimism in business sentiments.

Liquidity

Market participants were awaiting indications on additional liquidity management tools, given expectations of easy liquidity conditions on account of FPI flows on bond index inclusion and back-ended Government spending, especially in the light of OMO sales of more than Rs. 100 billion in July.

However, the RBI remained reserved in its liquidity management policy and reiterated that it would stay nimble and flexible in its liquidity management through main and fine-tuning operations.

Assessment of Real Rate

In its recently published monthly bulletin, the RBI’s DEPR (Department of Economic and Policy Research) revised its estimate of natural real rate to 1.4% -1.9% from 0.8%-1%, driven by the growth of potential output. (Source: https://rbi.org.in/Scripts/BS_ViewBulletin.aspx?Id=22718).

During the post-policy media conference, Deputy Governor Dr Patra stated that the natural rate estimate implies the current policy rate is close to neutral.

In our view, given that the research had estimated Q4FY24 potential output at 7% and the projected FY25 GDP for RBI is 7.2%, it may take a consequential decline in growth momentum or a sustainable disinflation close to its 4% target for RBI to interpret rates as restrictive and initiate monetary easing. This supports our longstanding shallow rate cut view as the current decline in inflation is largely cyclical and while growth momentum may slow but may not fall significantly.

Outlook – A shallow rate cycle in a period of easy liquidity is constructive for a moderate duration

As the Richmond Federal Reserve noted famously, the current monetary policy cycle has been “A Rate Cycle Unlike Any Other”!

Since the last RBI rate hike of February 2023, there have been only 7 instances out of 17 where inflation has printed below 5% and only one where inflation printed below 4.5%. Hence, as the RBI demonstrated tremendous patience when inflation comfortably ran above target due to repeated one-off shocks, they might similarly be patient and wait for hard evidence on growth or disinflation before initiating rate cuts.

In the near term, the yield curve has meaningfully flattened. Tight liquidity conditions due to lower Government spending and pushback of rate cut expectations in a period of positive demand-supply dynamics have led to the outperformance of the 15 year-plus segment of the sovereign yield curve.

However, we believe the short to medium (one-five year) duration segments may hereon outperform due to the following reasons:

1. The H2FY25 calendar could be heavier for Government bonds and state development loan supply. The H1FY25 calendar for the Centre was at 53.5% of annual gross borrowing compared to the last three-year average of 59% (Source: RBI). Actual borrowing in SDL was also lower at 57% of the Q1FY25 calendar (Source: RBI) compared to 67% (three-year average) due to higher state cash balances on account of General Elections.

2. Index-related flow demand should be more concentrated in the medium duration (5-10 year) post the exclusion of the new 14-year and 30-year Government bonds in the fully Accessible Route (FAR) securities.

3. Easier liquidity conditions and the ongoing moderation in credit growth could be more constructive for the short to medium-duration segment.

4. Clearer visibility on monetary easing on a moderating global growth environment and improved outlook on domestic inflation.

With 2 to 5 year AAA assets yielding between 7.50% and 7.60%, valuations for high-quality fixed income look attractive outright and are significantly attractive compared to overnight rates.

Investors with a 6-12 month horizon can consider an allocation to low duration/ money market strategies given the considerable gap between overnight and money market rates (up to 12 months).

Investors with more than 12-month investment horizon can consider allocation towards moderate duration (one-to-four year) categories.

The views expressed are author’s own views and not necessarily those of UTI Asset Management Company Limited. The views are not an investment advice and investors should obtain their own independent advice before taking a decision to invest in any asset class or instruments.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.