Monetary policy needs recalibration due to domestic reasons, not the Fed

Most investors believe emerging market central banks must follow the Fed. If they don’t, interest rate differentials can lead to significant capital flows and currency fluctuations.

Indeed, the Fed’s pivot to easing in September has opened the policy floodgates. In Asia, the Bangko Sentral ng Pilipinas cut the policy rate by 25 basis points (bps), and the reserve requirement ratio (RRR) by 250 bps, Bank Indonesia surprised with a 25-bp rate cut, and the People’s Bank of China cut the RRR by 50 bps, and the seven-day open market operation reverse repo rate by 20 bps. Is the Reserve Bank of India (RBI) next?

There’s no doubt a lower Fed rate hurdle helps, but, unlike other central banks, the RBI’s large foreign exchange reserves give it more leeway to focus on domestic considerations. In our view, it is the shift in the domestic growth-inflation balance since the August policy meeting that calls for a policy recalibration.

A more favourable inflation outlook

The outlook for food inflation looks more promising. A good kharif harvest and favourable rabi prospects bode well for the output and prices of rice, wheat, and pulses. High-frequency data shows a sequential fall in most food prices in August and September, although a surprising wedge has opened up between food prices as reported in the consumer price index (CPI) and those reported by the Department of Consumer Affairs, which appears to be a statistical anomaly.

Vegetable prices face inflationary pressures due to rains, but this is no longer a broad-based risk for food. Importantly, despite repeated food price shocks over the past year, this has not resulted in any second-round effects, as was the worry for policymakers. This means that, even though vegetable prices are a risk, they are more noise than signal from a policy perspective.

This view is also supported by other indicators. The CPI, excluding vegetables, which constitutes 94 per cent of the CPI basket, showed an inflation rate of only 3.1 per cent year-on-year (y-o-y) in August. The level of household inflation expectations (one-year ahead) is consistent with CPI inflation of 4-4.5 per cent. Our diffusion indices show that of the 290 items in the CPI basket, 67 per cent had an inflation rate of 4.2 per cent or lower in August 2024. To us, this suggests inflation is aligned to the 4 per cent target. When vegetable prices fall, headline inflation will not be at 4 per cent, but rather significantly undershoot 4 per cent.

Overall, September CPI inflation is likely to rise on account of an unfavourable base, but we expect CPI inflation to undershoot the RBI’s projection by 0.2 percentage points (pps) in Q2FY25 and 0.3 pps in Q3, with CPI inflation likely to average 4.4 per cent y-o-y in FY25 and 3.9 per cent in FY26.

Softer growth signals

Since August, growth signals have been weaker than expected. Q1 FY25 gross domestic product (GDP) growth at 6.7 per cent y-o-y was 0.4 pps below the RBI’s projections. High-frequency data so far in Q2 also suggests weaker-than-expected demand, with slower growth rates across passenger vehicle and medium/heavy commercial vehicle sales, diesel consumption, exports, GST collections, cement and steel, to name a few. Our nowcast suggests sequential growth momentum is weak, with GDP growth likely to remain below 7 per cent y-o-y, even in Q2. 

This moderation is partly due to transitory factors such as slower government spending and rains, but not entirely. Incremental credit growth is also moderating due to regulatory tightening. In the fiscal year to September 8, credit is up 3.7 per cent, compared to a normal run rate of 5 -5.5 per cent during similar periods. Some argue that financial conditions are easy, but this has not translated into a broad-based private capex revival or a sustained strength in urban discretionary demand.

Early reports suggest softer consumer demand at the beginning of the festive season, with discounts and incentives offered by automakers and online platforms to boost sales and clear inventory. Hence, while a pickup in government spending and better monsoon are positives for H2 FY25, the combination of policy-induced tighter credit, fading pent-up demand and softer global demand impulses are an offset. We expect GDP growth of 6.7 per cent y-o-y in FY25, with some of the softer growth impulses at risk of spilling over into FY26. An above-7 per cent GDP growth print is now looking less likely.

Tying it all together

Overall, food prices are cooling, and while vegetable prices are a risk, spillovers are less likely, with inflation ex-vegetables now in the 3-handle. Growth has been weaker than expected in Q1, and Q2 is looking soft as well. Brent crude oil prices have moderated closer to $70 per barrel, from $80 per barrel in August, and the Fed’s rate cutting cycle has started.

What this means for policy

Monetary policy is about balancing tradeoffs. In early 2022, when headline inflation was on the rise and policy rates were ultra-accommodative, the balance of risk called for a withdrawal of accommodation. Today, inflation is aligned to target, growth signals have started softening, and it is not clear if the latter is transient.

With softer signals from core inflation and growth, our takeaway is that there is economic slack, and the one-year forward real policy rate of 2.5 pps is above neutral. When there is space for policy recalibration, a visible shift in the growth-inflation balance and since monetary policy works with long lags, why wait?

Fed rate cuts may be the trigger, but there are domestic reasons for a recalibration of policy rates.

The author is chief economist (India and Asia ex-Japan) at Nomura