RBI Monetary Policy: Inflation continues to remain comfortably below 'tolerance'

During the first bi-monthly policy for the financial year 2023–24 (FY24), the Reserve Bank of India (RBI) made a surprising decision to keep its benchmark rate unchanged at 6.5% after delivering six consecutive hikes.

This pause in rate hike came as a surprise to market expectations, the RBI, however, assured that it was ready to take action if required.

Given the current inflationary conditions, which are below the RBI’s upper tolerance threshold of 6%, analysts are anticipating that the RBI will maintain the status quo on interest rates in its upcoming policy review scheduled for June 08, 2023. In fact, some market experts are even speculating on the possibility of a rate cut.

The retail inflation based on the Consumer Price Index (CPI) slowed sharply to 4.7% in April 2023, marking the lowest level since October 2021. Food inflation came in at 3.84% in April, the lowest since November 2021, with a fall in prices for vegetables and edible oil.

In comparison to the current period, the inflation rate during the same period of the previous year experienced a significant increase, reaching an eight-year high of 7.79%. This surge in inflation was primarily driven by a sharp surge in food and fuel prices, caused by the Russian-Ukraine war.

Around this period, RBI started raising interest and it has continued to do so until February 2023 in a fight against inflation, with six straight rate hikes, bringing the total repo rate to 6.25%.

However, inflation started easing in March 2023, dropping to 5.66%, and it has comfortably remained below the 6% upper threshold level of RBI.

The easing in retail inflation during April was led by the softening in overall food prices, led by vegetables, even as some sub-segments of the food index rose. Also, lower annualized growth in fuel, transport, and communication prices helped bring down headline inflation, said domestic brokerage firm Nuvama Professional Clients Group.

In the next 5–6 months, headline inflation will continue to benefit from the favourable base effect and is expected to progressively ease. However, upside risks to inflation prevail from imported inflation (rise in global crude oil prices) as well as domestic factors (lower crop output due to unfavourable weather and supply constraints), the brokerage noted.

In the absence of shocks, inflation is anticipated to stay below the RBI’s 6% upper tolerance band for the foreseeable future, it added.

Liquidity conditions have shifted from being tight to becoming surplus

In terms of liquidity in the domestic banking system, there has been a shift from a surplus situation to a tightening trend. From an average surplus of ₹6.5 lakh crore in April 2022, the liquidity has reduced to ₹0.7 trillion in May 2023. However, in recent days, there has been an improvement in liquidity conditions, with the surplus rising above ₹1.5 trillion, said the brokerage firm.

This improvement can be attributed to factors such as increased government spending, ongoing intervention by the Reserve Bank of India (RBI) in the foreign exchange market, and the recent withdrawal of ₹2000 currency notes.

The surplus liquidity in the banking system has cooled off the overnight rates, which dropped to 6.1% on June 2, 2023. Going forward, the brokerage expects the banking system's liquidity to remain in a moderate surplus, however, some offsetting impact on liquidity could emerge from a seasonal rise in currency in demand (usually seen at the start of Kharif season) and quarter-end tax outflows in June, it added.

Credit growth remains strong despite continuous rate hikes

Despite the increase in interest rates, there has been a significant rebound in bank credit offtake during FY23. The brokerage said this resurgence in credit has been observed across various segments, indicating a widespread improvement in the economy. It highlights the resilience of the economy and the ability of consumers to withstand the impact of higher interest rates, the brokerage noted.

“In terms of growth, the incremental (over March 22) credit offtake growth during FY23 has been 13.7%, while the comparable deposit growth stood at 9%. Amid relatively tighter liquidity conditions and healthy credit demand, banks have risen deposit rates, leading incremental deposit growth to also improve gradually.”

“This has resulted in a gradual improvement in incremental deposit growth. The positive trend is evident in the decline of the incremental credit-to-deposit ratio, which has dropped significantly from 112% in March 2023 and a peak of 135% in October 2022 to 61% as of mid-May 2023,” said Nuvama.

Growth momentum remains resilient, challenges ahead

Despite the challenges of weakening global growth and financial tightening, India's economy showed resilience and ended FY23 on a positive note. The GDP growth for FY23 stood at 7.2%, given the government's focus on capital expenditure, growth in the services sector, and the release of pent-up demand that boosted domestic activity throughout the year, the brokerage pointed out.

Despite the external factors, India's economic performance remained strong, reflecting the effectiveness of government initiatives and the buoyancy of domestic demand, it said.

Looking ahead, the brokerage expects factors such as good rabi crop prospects, sustained buoyancy in contact-intensive services, the government’s continued thrust on capex, higher capacity utilisation in manufacturing, and robust credit growth to remain supportive for India's growth impulses.

However, there are certain factors that may pose challenges to India's growth momentum. These include a slower revival of private capital expenditure and increasing global headwinds. These factors could potentially offset the positive growth drivers. Alongside, while inflation prints have started coming off their peak, underlying price pressure persists which could continue to weigh on consumer demand, according to the brokerage.

Additionally, tighter financial conditions, the fading of pent-up demand, and adverse climatic conditions could have ramifications on urban as well as rural economy. Given these push and pull factors, the brokerage expects India’s GDP growth to come in the range of 5.9–6.1% in FY24.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of MintGenie.