 "RBI Policy Preview: MPC's decision on interest rates hangs by a fine thread")
RBI Monetary Policy Preview: With the Union Budget for FY-2026 behind us, the focus now shifts to the next big event on the horizon – the Monetary Policy Committee's (MPC) final meeting for FY-2025, that is scheduled to be held later this week (February 5-7).
The incoming data since the last MPC meeting suggests that growth outcomes likely improved in Q3 FY2025 after the disappointing, lower-than-expected gross domestic product (GDP) print in Q2 FY2025. A healthy growth in kharif foodgrain output and the favourable trends for rabi sowing of wheat and rice point to a robust rise in agricultural gross value added (GVA). Besides, most high frequency indicators pertaining to the industrial and services segments have witnessed an acceleration in their year-on-year (Y-o-Y) growth rates in Q3 vis-à-vis Q2 FY2025.
Inflation outcomes have also improved, along expected lines. The consumer price index (CPI) inflation print cooled off from a 14-month high of 6.2 per cent in October 2024 to 5.2 per cent in December 2024. This moderation has largely been led by food inflation, which is expected to compress the headline print further to 4.6 per cent in January 2025, although this reading will only be available after the MPC's meeting.
Finally, the Union budget for FY2026 struck a fine balance between providing a growth impulse and sticking to the pre-committed fiscal deficit target. It has provided an equal thrust to domestic consumption and investment demand, with the sizeable income tax relief to individual taxpayers leading to a revenue loss of Rs 1.0 trillion to the Centre, and an equivalent increase in the budgetary capex target to Rs 11.2 trillion in FY2026 from the revised estimate of Rs 10.2 trillion for FY2025. The former would provide a boost to urban consumption which has been lagging for several quarters now. Besides, the latter along with the substantial increase in the grants-in-aid for creation of capital assets, would supplement investment demand.
These developments in the inflation-growth dynamics would provide comfort to the MPC. However, with the Indian Rupee recording a fresh all-time low against the US Dollar on Monday morning, following the announcement of tariffs by the US on Mexico, Canada, and China, the onset of rate cuts could be delayed to the April 2025 or the June 2025 meetings, until we are in the middle of relatively more comfortable inflation readings, as projected by the MPC.
This would also allow time to assess external developments, particularly around tariffs in the US, and ride out some uncertainty until the newly-elected US President settles down. Besides, it would also permit a better assessment of the US Federal Reserve’s outlook, given the tempering of expectations around rate cuts in the US in 2025. Meanwhile, the RBI could continue to manage liquidity conditions, to ensure that short term rates remain anchored to the repo rate and prevent a de facto rate hike, and assess how the INR-USD exchange rate evolves.
However, a delay in the onset of rate cuts is likely to entail some growth sacrifice, given the transmission lags associated with monetary easing. In contrast, an immediate onset of monetary easing in the upcoming meeting to the tune of 25 bps, followed by another cut in April 2025, would help support growth outcomes through the next fiscal. The combination of lower EMIs, easing inflation particularly for essential food items, and the increased discretionary income on account of the tax relief provided in the Budget, would augment household budgets and consumption demand. Besides, monetary easing along with the reasonable Government borrowing target for FY2026, would also help cool corporate bond yields. This could improve growth outcomes, amidst the uncertain global environment and the sluggish outlook for merchandise exports.
While there is a fear that the income tax relief measures could fuel inflation, we do not expect this to substantially alter the MPC’s projected CPI inflation trajectory for FY2026. Food inflation has been driven by supply-side issues, and the healthy outlook for crop output will augur well on this front, although vegetable inflation remains a question mark. Besides, core inflation has sustained at sub-4.0% levels for four consecutive quarters and is expected to inch up gradually through the next fiscal.
Overall, the MPC’s decision on rates in the upcoming policy hangs by a fine thread; while we think the probability is mildly tilted towards a rate cut, the trend in the INR-USD cross rate over the course of this week could as yet play spoilsport.
Aditi Nayar is Chief Economist, Head- Research & Outreach at ICRA. Views are personal.