RBI faces a delicate balancing act ahead of key monetary policy meet

It will be important for monetary policy not to inadvertently accentuate asset price inflation, financial exuberance and the associated financial stability risks that come with it

Over the last year, the Reserve Bank of India (RBI) has been resolutely focused on aligning headline consumer price inflation (CPI) to its 4 per cent target. This was both understandable and desirable. CPI inflation averaged 6 per cent for four years – between January 2020 and December 2023 – underpinned by the dual shocks of the pandemic and the war. To preserve the sanctity of the inflation targeting framework, it was crucial that once the economy began to recover from these shocks, the central bank would double down on aligning the CPI close to the point target.

To be sure, core CPI has been consistently below 4 per cent this year. This should be unsurprising once the goods and commodity price shocks of the last few years have faded because aggregate output is still below the pre-pandemic path – suggestive of existing slack – which, in turn, is likely exerting a gravitational disinflationary force on core prices.

Instead, the elephant in the room has been sticky and elevated food inflation – which constitutes 46 per cent of the CPI basket and is typically instrumental in shaping household inflation expectations. Food inflation has averaged close to 8 per cent since the middle of 2023 and was primarily responsible for keeping headline CPI above target. 

The good news is the outlook on food, and therefore headline, is looking increasingly constructive. A fulsome monsoon (108 per cent above normal) with improved spatial distribution, healthy sowing patterns (2 per cent above last year), replenished reservoir levels (13 per cent above normal, which bodes well for the winter crop) and benign global food prices, all point to an improved food inflation outlook. In fact, that process is already underway with headline CPI tracking 4.1 per cent in the July- September quarter and expected to average below 4.5 per cent in the October-December quarter.

But what about the outlook beyond the next few months?

In determining policy, the central bank will need to be looking at inflation over the next year. How should one think about that? This is where soft core inflation – which has averaged just 3.5 per cent in 2024 – provides some comfort. Why is that? Because we continue to find that when headline and core diverge – as they have this year – it is headline that eventually converges closer to core – over a four- quarter period – and not the other way around. 

This is because inflation expectations have been anchored for the most part – and softened over the last year – a testimony to the success of inflation targeting. Barring fresh shocks, therefore, benign core inflation should give the RBI more comfort about the outlook for headline CPI in 2025. 

The caveat, of course, is that the multiplicity of shocks (especially on food) has increased in recent years and policymakers will need to be wary of those risks.

Meanwhile, high frequency data on the growth front suggest some loss of momentum in recent months, as manifested in auto sales, cement production, power consumption, cargo traffic, petroleum consumption and GST collections. To be sure, the July-September gross domestic product (GDP) print should be boosted by strong agricultural output and progressive normalisation of government expenditure after elections. But policy will need to keep a very close eye on high-frequency data to ensure that any softness does not sustain or get more entrenched.

What could all this mean for monetary policy?

Ever since it stopped hiking in early 2023, the RBI has maintained a cautious “withdrawal of accommodation” stance to signal it is focused singularly on aligning inflation to the 4 per cent target. But now, with inflation risks abating, projected inflation closer to the 4 per cent target and signs of activity softening, it would seem appropriate for the RBI to pivot to a “neutral stance” that would recognise the changing reality while still allowing it to move in both directions.

Financial conditions relatively benign 

But if inflation is progressively aligning towards the 4 per cent target why not just cut rates in October, markets will ask. We believe at least two factors will weigh on the RBI:

n The proof of the pudding: Forecasts of food inflation durably settling at lower levels are, for now, just forecasts. Given the elevated nature of food inflation since the pandemic (averaging 6.6 per cent over the last 56 months) and the multiplicity of shocks that it has been subjected to, the central bank will likely want to see more evidence that food inflation not just softens but begins to settle there. For example, the monsoon has been very strong this year to the point of overstaying its welcome. If rains extend into October, they risk damaging the Kharif crop and, with it, expectations of sustained food disinflation. The RBI will therefore likely want to see evidence the harvest is progressing normally and having a salutary impact on food prices – just given the sheer weight of food in the basket – before pulling the trigger.  

> Geopolitical risks abound: Global risks are showing no signs of abating. Just when the impact of the

Russia-Ukraine war on commodity prices had faded, tensions in West Asia have flared up and crude oil prices have re-accelerated in recent days. While crude prices are still below $80 a barrel (as of writing this), they will need close monitoring because higher crude prices serve as a negative supply shock to India – simultaneously hurting growth while stoking inflation. Separately, the US Presidential election is just a month away, and a certain outcome is likely to materially increase the likelihood of US-China trade tensions ratcheting up significantly. A tariff war would likely induce Dollar strength, more broadly, and Chinese Yuan (CNY) weakness, more specifically – both of which are likely to stoke depreciation pressures on Asian currencies – making it harder for these central banks to ease. To be sure, India has a war chest of foreign exchange reserves which has bought the economy some monetary policy independence from the US Federal Reserve. But given the quantum of uncertainty the US election outcome poses, it is understandable why some central banks would want to see that uncertainty resolve before acting.

Given these two-sided risks, moving to “neutral” in the October policy will buy policymakers much- needed optionality to move in both directions. If global risks abate and domestic growth-inflation risks warrant an easing cycle, policymakers could quickly commence an easing cycle in subsequent meetings. If, instead, global risks spiral, policy can remain on neutral for longer.     

More fundamentally, one of the reasons the RBI can buy some time is because financial conditions, more broadly, remain relatively benign in India, as our Financial Conditions Index suggests (see chart). Elevated stock market valuations, compressed credit spreads, fulsome inter-bank liquidity, a very flat yield curve, and stable exchange rate have all combined to deliver easy financial conditions. Furthermore, bond yields in India have rallied almost 30 bps over the last few months, suggesting some components of financial conditions have only gotten easier in recent months. 

Markets, therefore, are running ahead of the RBI and so the latter can afford to wait to see how residual risks realise before acting.

The broader tension between monetary policy and financial stability 

But while easy financial conditions buy time for the RBI in the short run, they will serve as a source of tension for the central bank if it were to commence an easing cycle in response to domestic growth- inflation dynamics. 

This is because benign financial conditions are one thing. But there are clear signs that they have morphed into excessive financial exuberance in parts of the system. This was initially reflected in surging unsecured credit (which has since been dampened by RBI pressures) but still reflected in the ever- increasing equity market valuations (notwithstanding the recent market correction), the dramatic rise of Futures and Options trading – much of which happens on expiry days suggestive of rank speculation – and IPOs that are oversubscribed by orders of magnitude. 

The risk is that any easing cycle from the RBI – while warranted by the real economy – further eases financial conditions and stokes more financial exuberance, creating financial stability risks down the line.

To be sure, orthodoxy would suggest the appropriate policy response be governed by the Tinbergen Principle, wherein multiple objectives (“growth/inflation” and “financial stability”) are addressed through multiple instruments. In particular, the principle of “separability” would suggest monetary policy tools (rates and liquidity) be deployed towards growth and inflation whereas targeted macro- prudential measures be deployed across different regulators to rein in sectoral excesses.

This has been the approach pursued by regulators thus far. Late last year, the RBI increased risk-weights for unsecured lending and bank lending to NBFCs which has dampened unsecured lending growth. Furthermore, with the RBI leaning on banks to normalise credit-deposit ratios – which had increased in recent months – the expectation is credit growth will slowly asymptote towards deposit growth. 

On its part, India’s equity market regulator (Securities and Exchange Board of India, or Sebi) correctly clamped down earlier this week on Futures and Options trading through a series of macro-prudential measures – increasing the minimum trading amount for derivatives, reducing expiries of derivatives to one per exchange per week and increasing margin requirements.

So far so good. This approach underscores the value of “separability” – using macro-prudential measures to rein in financial exuberance to free up monetary policy to respond to growth-inflation dynamics. But policy makers will need to be careful, because while separability is clean in theory, it is messier in practice:

> First, as former Fed Chairman Ben Bernanke has noted, there is growing evidence that monetary easing promotes increased private-sector risk taking, dubbed the “risk-taking channel of monetary policy”. The implication: even if macro-prudential measures are deployed for financial stability, they risk being undermined if monetary policy is simultaneously being eased. In India’s case, for example, an easing cycle may induce credit growth to re-accelerate and re-ignite credit-deposit concerns. Or it may stoke another cycle of unsecured lending. Or it may stoke even more exuberance in equity markets and other asset classes.

> Second, macro-prudential measures may not reach all parts of the financial system. In contrast, as Former Fed Chair Jeremy Stein notes, monetary policy “gets into all the cracks”. So even as tighter, targeted macro-prudential measures can address some – but not all – excesses, they risk being offset by easier monetary policy which eventually impacts the entire system. 

Monetary policy and financial stability can therefore never be fully mutually exclusive. Furthermore, this tension is not unique to India. Several central banks in the region (Bank of Korea, Bank of Thailand) are  confronting the same trade-off – financial excesses (typically elevated household debt leverage) that is impeding their ability to respond to softening inflation for fear of stoking financial instability risks down the line.

Not for a moment is this to suggest a “financial dominance” of India’s inflation targeting framework. The framework has worked very well and monetary policy should therefore focus primarily on its inflation targeting mandate, as was intended. So if growth-inflation dynamics warrant an easing cycle, that is what the RBI should focus on. 

The simple point, however, is that any easing cycle may spawn even more risk-taking behavior across asset classes which policymakers should anticipate, carefully monitor, and be ready to offset through a continued calibration of macro-prudential measures. Any monetary easing cycle will therefore likely need to be accompanied by commensurate macro-prudential tightening – of the kind seen earlier this week.

Lower inflation comes as macroeconomic relief. But in responding to softer goods and services inflation, it will be important for policy not to inadvertently accentuate asset price inflation, financial exuberance and the financial stability risks that come with it. 

The writer is Head of Asia Economic Research at J P Morgan