Once Efforts On Inflation Control Bear Fruit, RBI Will Start Reducing Repo Rate

Headline inflation is not likely to come to the acceptable level of four per cent per cent in the recent future and possibly only in the second quarter of the next financial year

The headline inflation increased substantially to 6.2 per cent, which is way above the RBI target of for per cent.

According to Reserve Bank of India (RBI), a factor was the CPI food inflation, which surged to 8 4 per cent in September and firmed up further to 9.7 per cent in October 2024 from an average of 5.2 per cent in July -August. As a result, the contribution of food group inflation with a weight of 45.8 per cent in CPI basket to headline inflation in increased from around 68 per cent during July-August to around 74 per cent.

Another surprise data was the substantial fall in real GDP growth to 5.2 per cent in Q2 2024-25. This was mainly due to the subdued performance of manufacturing companies, fall in urban demand, contraction in mining activities and lower electricity demand. Given this background, there was a feeling that high inflation and consequent high repo rate at 6.5 per cent has started to affect the growth adversely.

Up to the Q2 data on real GDP, the repo rate at 6.5 per cent continued with status quo on earlier policy as RBI has yet to get their comfortable level of target of four per cent inflation on a durable basis.

After extensive discussions from December 4 to 6, MPC members, by a 4 to 2 majority, decided to keep the policy repo rate unchanged at 6.50 per cent. RBI also decided unanimously to continue with the neutral stance.

On the current policy front, RBI has revised upwards the inflation forecast for 2024-25 from the earlier level of 4.5 per cent to 4.8 per cent with Q3 at 5.7 per cent and Q4 at 4.5 per cent. The RBI further projects that CPI inflation for Q1 2025-26 would be at 4.6 per cent and Q2 at four per cent. This indicates that headline inflation is not likely to come to the acceptable level of four per cent per cent in the recent future and possibly only in the second quarter of the next financial year.

As control on inflation is not a completed task and the last end of the inflation trajectory looks long, the central bank has decided to stay firm on repo rate unchanged. RBI Governor Shaktikanta Das attributed this to the bank’s anti-inflationary monetary policy stance.

Das has stated that the timing of reduction in repo rate becomes critical because of which they were implementing carefully calibrated measures to derive the maximum benefits.

Gaining full control on inflation across fronts on a sustainable and durable basis will be a positive in the long run.

On the other side, RBI, which was firm on real GDP growth at 7.2 per cent for 2024-25, had to finally concede that this was not feasible in the background of downfall in GDP growth to 5.2 per cent and revised downwards by 60 basis points to 6.6 per cent for 2024-25. The current growth projections match the government projection of 6.5 per cent.

Even to achieve the revised projections, both manufacturing and service sector have to perform better like in October and the exports sector should show good growth. In order to achieve this, the Centre and states have to accelerate capex expenditure according to the budget levels, and private sector investment should be duly enhanced. Agriculture, which had showed better growth in Q2, is likely to perform better in the next two quarters.

In its bid to ease the potential liquidity stress, the RBI has decided to reduce the cash reserve ratio from 4.5 per cent to four per cent in two stages of 25 basis reduction from the fortnight beginning December 14. This will restore the position to four per cent, prevalent before the commencement of the policy tightening cycle in April 2022. This reduction of 50 basis points in CRR will release primary liquidity of about Rs, 1.16 lakh crore to the banking system. Reduction of CRR will help manage the market rates within the acceptable levels. It will have n indirect impact on reference rates without really bringing the repo rate. If there is a further need for liquidity and to ensure banks are able to meet the productive credit requirements, the RBI may further reduce CRR rate.

In order to banks efforts to enhance resource mobilisation from foreign currency deposits, the RBI has increased foreign currency deposits of one year to less than three years maturity at rates not exceeding the ceiling of overnight Alternative Reference Rate (ARR) plus 400 basis points as against the current 250 bps. Similarly for deposits of three to five years maturity, the ceiling has been increased to overnight ARR plus 500 bps as against the present 350 bps. This relaxation will be available till March 31, 2025.

In order to defend the volatility in the rupee vs dollar rate in the background of substantial portfolio investments shifting from emerging economies, the central bank was compelled to use part of their forex reserves, which, incidentally from an all-time high of $704.885 billion came down to $658.090 billion on November 28. It is therefore necessary for banks to provide better foreign currency deposits rates to mop up higher foreign currency deposits. This will undoubtedly add to our forex reserves.

India's macroeconomic fundamentals are strong. There are favourable indications that the real GDP growth will also grow according to the current budgeted level and even at 6.5-6.8 per cent, the country’s real GDP growth is much appreciable in the light of the global uncertainties. The combined efforts of the government and the private sector made it possible. Meanwhile, the steps being taken by the central bank will bear fruit on inflation control efforts. That is when the RBI will start reducing repo rate.

(The author is former Chairman & Managing Director of Indian Overseas Bank)