During the October 2023 meeting, the Monetary Policy Committee (MPC) unanimously decided to keep the policy rate unchanged and maintained a 5:1 vote in favor of its existing stance. As expected, the tone of the meeting leaned towards a hawkish perspective, emphasizing the priority of reducing inflation to meet the 4.0 percent medium-term target. A noteworthy development was the discussion about the potential use of open market operations (OMO) sales for liquidity management, causing a notable increase in Government securities yields.
In the subsequent weeks, positive developments have emerged regarding inflation. The headline Consumer Price Index (CPI) inflation, which stood at 7.4 percent in July 2023, had already decreased to 6.8 percent by August 2023, before the last Monetary Policy Committee (MPC) meeting. Subsequently, it further declined to 5.0 percent in September 2023 and 4.9 percent in October 2023, partially due to the augmented LPG subsidy. The anticipated reversal in tomato prices and a seasonal decline in various vegetable prices with the onset of winter have contributed to this decrease, although concerns have arisen due to the escalating prices of onions.
The 2023 monsoon displayed irregular patterns, and the initial estimates for the kharif crop indicate reduced output across major crop categories. Looking forward, reservoir levels are notably lower compared to the previous year and historical averages. The sowing of rabi crops has also lagged behind the levels observed in the post-Diwali week of the previous year. The outlook for food grain prices appears grim, even though some of the negative developments have already manifested in the October 2023 CPI figures.
The Consumer Price Index (CPI) inflation is projected to rise to 5.6 percent by December 2023 and then fluctuate within a broad range for the subsequent two quarters. Following that, a favorable base effect is anticipated to temporarily lower inflation in Q2 FY2025. We anticipate the CPI inflation to be at 5.3 percent in FY2024, slightly below the Monetary Policy Committee’s (MPC) estimate of 5.4 percent. With a relatively normal monsoon, inflation might ease to 4.7 percent in FY2025, although it is expected to remain moderately above the 4.0 percent target.
Regarding economic growth, the MPC will have the Gross Domestic Product (GDP) growth figures for Q2 FY2024 during its December 2023 meeting. The normalization of the base and the uneven monsoon are likely to restrain GDP expansion to 7.0 percent in Q2 FY2024, down from 7.8 percent in Q1 FY2024. However, we argue that the pace of GDP growth in this quarter will surpass the MPC’s October 2023 projection of 6.5 percent.
Looking forward, the outlook for GDP growth in the second half of FY2024 is less optimistic. The impact of the base effect will persist, visually moderating growth in specific sectors. Furthermore, challenges such as a gloomy agricultural outlook, the cumulative effects of monetary tightening, and subdued external demand will act as obstacles. Additionally, two other factors are anticipated to slow down the momentum in value-added growth and/or dampen sentiment: the narrowing differentials with year-ago commodity prices and a potential deceleration in the pace of Government capital expenditure as the Parliamentary Elections approach. There is concern that GDP growth in the second half of FY2024 may fall below 5 percent. Consequently, we predict the GDP growth for FY2024 to be 6.0 percent, which is lower than the Monetary Policy Committee’s (MPC) projection of 6.5 percent.
In the context of domestic inflation and growth, coupled with geopolitical uncertainties contributing to global economic lethargy, we anticipate an extended pause from the MPC. In our assessment, there is currently no compelling need for further monetary tightening, given the sustained transmission of the previous rate hikes. The threshold for another rate hike would be quite high, necessitating clear evidence that inflation is poised to persistently exceed the MPC’s forecasts for at least two quarters, along with indications of pressure transmission to core inflation.
Meanwhile, the emphasis on returning inflation to the 4.0 percent target implies that rate cuts are not imminent. We anticipate a prolonged pause on the policy rate and a consistent stance throughout FY2024. Subsequently, a modest cycle of rate cuts, ranging between 50-75 basis points, may commence only in August 2024.
Concurrently, the latest minutes from the Federal Open Market Committee (FOMC) have dampened expectations of an early rate cut in the United States. We believe that central banks will exercise caution before declaring victory over inflation and implementing rate reductions unless there is a looming external shock to economic growth.
This brings us to the unexpected announcement accompanying the last policy review: the potential use of Open Market Operations (OMO) sales to absorb excess liquidity. Liquidity conditions have generally remained tight since the early-October 2023 policy meeting, with occasional relief, evident in sustained substantial borrowings through the Marginal Standing Facility and elevated levels of the Weighted Average Call Rate compared to the repo rate. Interestingly, this tightness has persisted despite Government securities redemptions totaling Rs. 1.1 trillion in November 2023 so far (up to Nov 28, 2023), suggesting that the Government of India’s cash balances have remained elevated.
While there might be a temporary decrease in early December 2023, systemic liquidity is expected to undergo significant tightening in the latter part of the month. This is attributed to the simultaneous outflows of advance tax and GST payments, unless these are counterbalanced by substantial expenditures during the same period. As a result, unless there are substantial capital inflows preceding the bond index inclusion, Open Market Operations (OMO) sales may not come to fruition.
