View: RBI holds rates but uncertainty looms due to multiple pressure points

By Dipti DeshpandeThe Reserve Bank of India’s Monetary Policy Committee (MPC) in its June policy review unanimously decided to leave policy rates unchanged and retain a neutral policy stance – an outcome that was largely expected. At 5.25%, the repo rate remains below its decadal average and the levels seen in fiscal 2014 when the rupee depreciated sharply over a brief period. That had prompted interest rate and non-rate interventions to arrest the currency’s steep decline.Much has changed since then. The central bank has formally adopted an inflation-targeting framework that shepherds its policy rate decisions, while its approach to exchange rate management is clearly rooted in containing excessive volatility rather than defending specific levels of the rupee. Second, policy rate adjustments have become relatively measured, with greater emphasis on liquidity management to ensure liquidity conditions align with the policy stance. Finally, communication has assumed a more prominent role, a tool which central banks have over the past decade have increasingly relied on over the past decade, particularly during periods of stress, to minimise policy uncertainty and anchor inflation expectations, both critical for macroeconomic stability. This policy review was no exception. Communication took centre stage, especially since the RBI stayed pat on the rate and stance despite mounting pressures on inflation, growth and the external sector. While reiterating its commitment to inflation control and liquidity support, the central bank chose to adopt non-interest rate measures to attract foreign capital flow to support the rupee. Alongside the government’s decision to provide capital gains tax relief for foreign investors in government securities, the steps represent more durable efforts to strengthen capital flows. However, in the near term, the rupee faces pressure from adverse external dynamics and India’s high dependence on energy imports. These external pressures are also weighing on domestic financial markets. The confluence of conflict-induced inflation, fiscal concerns, high crude prices, elevated government bond supply and rising global sovereign yields, particularly in advanced economies, is hardening domestic government bond yields. Inflation dynamics, meanwhile, are shifting. Over the past few weeks, price pressures have begun to pass from producers to consumers, driven more by cost-push than demand-driven forces. The four retail fuel price hikes in May, along with second-round effects through higher transport costs and rising prices of other industrial inputs, are expected to reflect in retail inflation in coming months. Against this backdrop, the RBI raised its forecast for inflation based on the Consumer Price Index for this fiscal; it sees the print up 50 basis points (bps), ~30 bps of which is led by higher expected core inflation.The MPC raised its inflation forecast to 5.1% but chose to look through the supply-side pressures; it will remain alert to risks from global price shocks and monsoon uncertainties. Its growth forecast moderated to 6.6% from 6.9% for the fiscal, reflecting the dampening impact of higher energy prices and supply disruptions to economic activity. At present, the RBI’s inflation and growth forecasts for this fiscal align with Crisil’s projections.The forecasts remain contingent on global supply chain conditions and monsoon disruptions. Three months into the West Asia conflict, its repercussions are manifesting. Energy price spikes and supply constraints have intensified economic pressures, with inflation risks elevated; the growth impact is expected to unfold gradually. Notably, the effect across India’s macro indicators is non-uniform, since those with weaker starting points—rupee and government bond yields—have been hit harder. A potentially uneven and inadequate monsoon could further exacerbate these pressures. Globally, the growth impact is moderate so far, while inflation is materially higher, prompting central bank policy shifts. The central banks of several advanced economies, including European Central Bank, Bank of England and Bank of Japan, are expected to move towards monetary policy tightening this year. In contrast, Asian central banks have adopted divergent approaches. While central banks in Indonesia and the Philippines have acted on currency and inflation pressures and raised policy rates, others have deployed non-rate measures.The RBI lies in the second group, opting to pause rate action and assess the impact of global disruptions on growth and inflation, while deploying non-interest rate measures to support its currency. However, unlike many of its peers, the RBI faces the additional uncertainty of monsoon and food inflation. In this complex and fluid environment, the Indian central bank’s approach points to its preference for calibrated policy restraint with targeted interventions and clear communication.Clearly, there are clouds on the horizon, and not just those bringing the southwest monsoon to India’s shore. (The author is Principal Economist at Crisil Limited. Views are personal.)