There is a clear global shift towards lower interest rates as downside risks to growth increase. The post-pandemic fight against inflation is nearing its conclusion, with supply chains normalizing and demand-side pressures easing. Several developed central banks, diverging from the U.S. Federal Reserve has already initiated rate cuts in response to weakening domestic growth conditions. Furthermore, the U.S. Fed is expected to begin its rate cut cycle in September as signs of labor market weakness emerge. Additionally, easing commodity prices are further contributing to the moderation of inflationary pressures.
Today, developed central banks have recognized that the window for delaying policy action has narrowed due to increasing risks to growth. In contrast, the Reserve Bank of India (RBI) remains in a relatively favorable position, allowing it to carefully assess the sustainability of the disinflation process. Given this situation at hand, robust domestic growth conditions provide the RBI with the flexibility to maintain its current stance. However, achieving a soft landing will require a gradual reduction in interest rates rather than waiting for clear signs of growth weakness. This approach is critical, as monetary policy typically takes two quarters to fully impact the economy; waiting for growth to falter before cutting rates may prove too late.
Mitigating Challenges
So, is it necessary to wait for signs of growth weakness to justify a shallow rate cut cycle? Are the current high growth conditions indicative of an overheating economy? Over the past three years (FY22 to FY24), real GDP growth has averaged an impressive 8.3%. This robust growth has coincided with core inflation easing to historical lows and the current account deficit shrinking to 0.7% of GDP in FY24. These indicators suggest that the economy is growing below its potential, with no signs of overheating.
Part of this strong growth reflects a catch-up from the lost momentum during the COVID-19 pandemic. Had the COVID-19 shock not occurred, real GDP levels in FY24 would likely be higher. Therefore, the argument that strong growth conditions should preclude rate cuts due to the risk of overheating does not hold.
A Robust Bank Credit Growth
One argument against initiating rate cuts is the exceptionally strong bank credit growth, currently tracking at 15.1% year-on-year (excluding the impact of a recent bank merger with a non-bank). While this credit growth is robust, it is only marginally higher than nominal GDP growth. Adding to it, this growth has coincided with improvements in credit quality, with the banking sector's Gross Non-Performing Assets (GNPA) at multi-year lows.
So, what is holding the RBI back from beginning a shallow rate cut cycle? It’s not concerns about growth, but rather uncertainty surrounding the inflation outlook. Food inflation has remained persistently elevated since FY23, driven by successive supply-side shocks. Moreover, these inflationary pressures have been broad-based, affecting cereals, pulses, and vegetables.
Recent debates have questioned whether monetary policy should be overly influenced by food inflation. This discussion has gained traction as elevated food inflation has coexisted with core inflation at historic lows, suggesting that the economy is growing below its potential and creating room to ease policy rates. However, members of the Monetary Policy Committee (MPC) have addressed this debate, emphasizing that due to the close relationship between household inflation expectations and food inflation, monetary policy cannot overlook food inflation. Additionally, food inflation accounts for nearly 50% of the weight in the Consumer Price Index (CPI) basket.
Currently, there are no signs of food inflation spilling over into core inflation, despite a marginal increase in household inflation expectations. This can be attributed to the fact that last year's company profit growth was bolstered by a sharp reduction in input costs, enabling companies to absorb incremental price pressures. However, going forward, core inflation is expected to gradually rise as companies begin to pass on input cost pressures. Therefore, the outlook for food inflation remains critical for the overall inflation trajectory.
The progress of the monsoon will be a critical factor in determining food prices, given that only 57% of the agricultural area in India is irrigated. Fortunately, the spatial distribution of rainfall has been favorable, with 60% of the country receiving normal rainfall. This positive development is already reflected in daily food prices, which have started to ease in August. A clearer picture of the food inflation outlook will emerge once the monsoon season concludes.
Conclusion
So to say, considering the domestic and global context, conditions appear conducive for a shallow rate cut cycle, likely beginning in Q4 2024 (October or December meeting). The RBI is expected to reduce interest rates by 50 basis points by the end of FY25.
About the Author
Gaura Sen Gupta, Chief Economist at IDFC FIRST bank is a competent leader with her indepth research focusing on Macro and Markets, covering both FX and Fixed Income. She brings with her over 16 years of unparalleled experience in Macro Economic Research. If we speak of her educational journey, she completed her Masters from Delhi School of Economics.
