The MPC hiked policy rates by 25 bps as was widely expected. Alongside, and against market consensus view, the stance was changed to ‘calibrated tightening’.
The policy acknowledged the rise in global risks including from energy prices, trade uncertainty, rising bond yields in advanced economies, and appreciating dollar. Despite these and other evolving risks, the domestic economy is largely deemed to be strong. Strong private consumption and fixed investment, rebound in merchandise exports and sustained buoyancy in services exports are all supporting growth. High frequency indicators for July – August also suggest sustained momentum in domestic activity though risks remain from global economic uncertainty, supply chain disruptions, as well as weather events. All told, real GDP forecast for FY27 is revised higher by 40 bps to 7.1%, with Q1 FY28 also assessed at 7.1%.
On inflation, the MPC notes the recent pick up on account of food and fuel inflation, as well as signs of widening of price pressures in a range of commodities. In addition, early signs of inflation becoming generalised are also evident from the increase in core inflation and higher inflation across a larger segment of the CPI basket. CPI forecast for FY27 is revised higher by 20 bps to 5.2%, and Q1 next year by 30 bps to 5.6%.
Notable Points:
- The MPC is categorical in clarifying what the change in stance means: it only signals that given the current conditions, rate cuts are off the table in the near term and policy action ahead can only be a rate hike or a pause, depending on the evolving conditions and the outlook. More specifically, by itself it says nothing about the duration or extent of the rate hike cycle. As the MPC clarifies, this would be contingent on the actual growth-inflation developments and outlook, especially that of underlying inflation, the extent of broadening of price pressures and second round effects of the supply shock, as also the impact of demand impulses.
- The MPC elaborates that as regards supply side inflation, monetary policy primarily acts by curtailing second round effects (inflation expectations and firm level pricing behaviour, etc.), which take time to manifest and are difficult to extract from available data. Apart from data related to inflation expectations and firm level pricing behaviour, indicators of generalisation of inflation like core inflation and diffusion indices are used for this purpose. At the same time, it points out that it is difficult to distinguish between the second-round effects and the indirect impact of supply side pressures (in production cost through energy and other inputs) as both are present in these indicators. It notes that while there is some evidence of elevated inflation expectations and generalisation of inflation, there are only limited signs of supply side pressures getting embedded in pricing behaviour.
- Also very importantly, it notes that while there is limited evidence of demand side pressures, risks in view of strong growth in monetary and credit aggregates exist.
Assessment and Views:
Our assessment framework remains that the best way to navigate current global macro is via its most dominant ongoing theme: this is first and foremost an intense global competition for capital. Fiscal policy resets in large parts of the developed world seem handing over the growth baton to AI related private sector capex. Thus, the US economy is now averaging 6.2% nominal growth rate since 2020 vs 4.1% in the 9 years before that. More recently, after a period of slowdown since mid of last year, the US seems to be reaccelerating. This, as well as more debt financed capex on AI buildout, has led bond yields even higher. Importantly this last leg up in US bond yields is entirely owing to ‘real’ bond yields rising rather than any change in inflation expectations. Indeed, with growth indicators strong and Fed credibility getting a fresh boost, the dollar index has recently strengthened.
The higher setting on global neutral real rates, along- side broad based pressure on a host of commodity prices, provide context for the monetary policy review today. Irrespective literal translation of the stance, the change of it was important to provide more heft to the hike today and communicate readiness for the future. That said, this is an exceptionally hawkish global macro environment and we remain an energy importing, current account deficit country that needs its fair share of dollar flows. To that extent and has been the case for most of past one year, there is limited effect that RBI can have in managing local financial conditions. Further, while monetary policy is set for local reasons, the degrees of freedom available to it are determined by global factors as well. In the present case higher global real yields and broad-basing commodity pressures provide limited degrees of freedom for RBI / MPC. Our view is of total rate hikes of 100 – 125 bps including the one done today. Also, while the liquidity management objective currently is only to align weighted average call rate to policy rate, the reference to strong growth in monetary and credit aggregates as potential risk factors for demand side inflationary pressures is notable.
We remain conservatively to very conservatively positioned on duration risk across a host of our fixed income funds. We will look closely for any signs of moderation in the global themes discussed above. As always, this reflects our current view and thinking and this may change at any point going forward.
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