RBI MPC: FX, not inflation, curbing degrees of policy freedom

Hence, we believe that in an increasingly volatile world, degrees of freedom for the RBI’s monetary policy committee (MPC) to ease policy to support growth would be constrained more by foreign exchange (FX) movements rather than inflation. 

While bond markets now anticipate rate cuts “sooner rather than later”, we see the reverse and would want to closely watch global volatility trends to decide on timing of monetary policy shift in India. From an academic perspective, usually “economics trumps politics” but we believe that during Trump 2.0, it is crucial for policymakers to stay cautious. 

In terms of the MPC outcome due on 6 December, we align with the consensus view of no change in rates. 

Also Read: MPC to keep rates unchanged amid slowing growth, rising inflation

The size of the hump in October CPI or consumer price index-based inflation at 6.21% was a surprise for the MPC, with the October-December average inflation tracking close to 5.5%, way above their forecast of 4.8%. This is likely to remain a cause for concern for the inflation- targeting MPC and stay the prime driver of the rate decision. 

The catch though in our view is that the Q4 FY25 inflation forecast is still tracking close to the MPC’s forecast of 4.2%, assuming that the spike in vegetable inflation to record high 42% in October, squares off by the end of the fiscal as per seasonal trends. Unless weather again plays spoilsport for food inflation, the overall macro environment is non-inflationary in our view, with weak demand pressures, low fiscal and credit impulse, subdued commodity prices (especially oil) among others. FX channel may play spoilsport though sensitivity is low as RBI estimates 5% rupee depreciation to drive annual CPI inflation higher by 35 basis points. 

Hence, we believe that it is not the forex impact on inflation; rather, the need for interest rate defence for FX in the wake of persistent depreciation pressures is likely to drive monetary policy reaction. 

In a world rife with political and economic uncertainty, with all eyes on Trump taking office on 20 January 2025, FX volatility may remain as usual for at least the coming months. We must compliment the RBI for undertaking efforts to contain volatility even as it has costed it close to $50 billion of spot reserves (on intervention efforts and valuation effects as of 22 November) with the liquidity impact estimated at ₹1.5-2 lakh crore.  

Additionally, to defer the liquidity impact, the RBI has extended the net short forward position to $50 billion (latest data as of October) from $15 billion short a month ago. Hence, domestic FX and consequently, banking system liquidity have been the primary channel(s) of impact from Trump trade. 

The core liquidity which was close to ₹5 trillion as of end September has been squeezed out to nearly ₹1 trillion by last week of November on FX intervention and currency leakage effects.

A slip into sustained deficit is likely in the coming months until FX outflows reverse, given that the seasonal currency leakage of ₹1.5-2 trillion is still pending for the rest of the fiscal year.  

Also Read: When food inflation became main course on MPC menu

In this backdrop, there are two key burning questions as we head into this MPC meeting: 1) Is the time ripe to shift to permanent liquidity tools to offset liquidity loss on FX operations? 2) How does RBI now view the growth scenario post GDP data shock?

Regarding the first question, it is well known that the RBI has various tools at its disposal to prop up liquidity–fine-tuning operations (variable rate repos and term repos) and permanent tools like cash reserve ratio (CRR) cut, open market operations or OMO buybacks, buy/sell FX swaps among others. In our view, FX swaps may be preferred, given that the loss to liquidity has also been permanent. Also, with the RBI’s objective of curbing credit excesses in the banking system and with credit-deposit growth convergence achieved, the central bank may show some comfort to the banking system via a signal to use steps to infuse liquidity as it likely slips into deficit by Q4. 

In terms of tools, we have a bias against the use of CRR cut to boost liquidity. We believe that it is a policy signal and would indicate that the inflation horse is fully locked up in the stable and growth concerns are more dire rather than a one quarter blip. Hence, we would closely watch out for reference towards other tools in the RBI’s kitty like OMOs, FX swaps among others to support liquidity. 

Regarding the second question. we would closely monitor the MPC’s guidance on growth post the surprise from September quarter GDP numbers that slipped to 5.4% versus their forecast of 7%. 

In FY24, RBI was more optimistic about growth vis-à-vis economists and turned out to be correct. However, in FY25, the latter have been more accurate in their estimates for slower growth. Hence, we will closely watch for the extent of downward revision in the full-year growth forecast of 7.2%, even after asserting hopes of recovery in the second half of the financial year, pinned on government spending pickup and rural demand recovery. 

On balance, while this may be a status quo for MPC in terms of rates, as signalled by the RBI governor himself in recent media interactions, it is eagerly awaited with close watch on guidance on macro outlook and liquidity measures. 

Kanika Pasricha, chief economic advisor, Union Bank of India. Views are personal.

Also Read: RBI’s GDP projections on test as India’s Q2 GDP growth falls short