Comfortable position: Low inflation may not lead to another rate cut

The data released on Monday showed that the Consumer Price Index-based inflation rate declined to 2.1 per cent in June, as against 2.8 per cent in May. The decline was largely driven by lower food prices. The all-India Consumer Food Price Index declined by 1.06 per cent, mainly because of lower vegetable prices, which dropped by 19 per cent. Given the forecast of a good monsoon, food prices are expected to remain in check. However, it is worth noting that within the food segment, the moderation in prices is not uniform. Prices of oils and fats, for example, increased by over 17 per cent and may require policy attention. Nevertheless, the headline rate is expected to remain at comfortable levels in the coming months. 

However, a lower than expected inflation rate is unlikely to prompt the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) to further reduce the policy repo rate in its upcoming August meeting for a variety of reasons. First, anticipating favourable inflation outcomes, the MPC frontloaded the rate cut in its June meeting by reducing the policy repo rate by 50 basis points. Thus far, it has reduced the policy rate by 100 basis points in the current cycle and would want to wait for it to work through the system. Second, the RBI has taken several measures to ease liquidity conditions in the system. As a result, owing to significant surplus liquidity, the weighted average call rate (WACR) — the operational target of monetary policy — is trading below the repo rate. More liquidity is expected to flow into the banking system as the reduction in the cash reserve ratio (CRR) takes effect. The RBI had reduced the CRR by 100 basis points in June, to be implemented in four tranches. Given the surplus liquidity and the WACR trading below the policy rate, the MPC may not want to increase accommodation immediately. 

Third, monetary policy needs to be forward-looking and not be influenced by last month’s inflation reading. It is worth pointing out that the June meeting of the MPC projected the inflation rate at 4.4 per cent for the fourth quarter of this financial year, and that is above the target of 4 per cent. Besides, in August and subsequent meetings, the MPC would start focusing on inflation projections for 2026-27. Further, while the headline rate has declined substantially, the core rate is running above 4 per cent. Therefore, unless the inflation projections for next financial year are substantially lower than the target of 4 per cent, which look unlikely at this stage, the MPC may not find it prudent to reduce the policy rate further. 

Research by RBI economists has shown that the natural rate, or the real policy rate that is neither contractionary nor expansionary, is 1.4-1.9 per cent (Q4FY24). Thus, assuming the inflation rate remains around the target of 4 per cent in the foreseeable future, the MPC will likely keep the repo rate at the current level of 5.5 per cent. The possibility of a rate cut will arise only if inflation projections are significantly lower than the target. In terms of supporting growth, as things stand, the MPC and RBI have done their bit. It is now for the government to encourage Indian businesses to invest with sustained reform efforts.