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The Reserve Bank of India (RBI) has taken a significant step by shifting its monetary policy stance from 'withdrawal of accommodation' to 'neutral,' indicating a potential shift towards easing interest rates. This decision, driven by both global and domestic economic factors, reflects the RBI's focus on balancing growth and inflation. The shift to a neutral stance grants the RBI greater flexibility in managing liquidity, enabling smoother transmission of policy rates into broader interest rates.
The global landscape has seen a trend of central banks easing policy rates and injecting liquidity, influenced by changing domestic growth and inflation dynamics. While commodity prices have experienced recent increases following stimulus announcements from China, the broader picture points to slower global growth, evident in declining oil prices due to weak demand. Despite heightened geopolitical risks, oil prices have not sustained above $80 per barrel.
On the domestic front, while some economic indicators have been underwhelming, indicating growth concerns, the RBI has maintained its growth estimate for FY25. The lower-than-expected Q1 growth stemmed from reduced government spending, and Q2 growth is anticipated to be impacted by above-normal rainfall during the monsoon season. Despite revising H1 growth downwards to 6.9% from 7.1%, the RBI has raised H2 growth to 7.4% from 7.3%, preserving the overall projection at 7.2%. However, the possibility of a downward revision to the projection by December cannot be ruled out, potentially leading to a rate cut in December.
A positive outlook for medium-term food inflation, driven by the above-normal monsoon, also contributes to the shift in stance. The RBI's medium-term forecasts are optimistic, with projections of 4.2% and 4.1% for March 2025 and 2026, respectively. This positive outlook stems from the expected deceleration in food prices and the current assumption of oil prices at $80 per barrel, down from the previous estimate of $85 per barrel.
The shift to a neutral stance opens the door for potential rate cuts, aiming to ensure that real interest rates do not become high enough to stifle growth. The extent of possible rate cuts depends on future economic projections. Given the current projections for FY25 and FY26, real rates are significantly above the RBI's neutral rate range of 1.4-1.9%. Assuming growth remains above 7%, the higher end of the neutral rate range would necessitate a 50bps rate cut. However, if global growth weakens and India's domestic growth slows, the neutral rate could shift towards the midpoint of the range, potentially requiring a 75bps rate cut.
The timing of a rate cut is a key question. December odds are currently above 50%, with weaker domestic growth, medium-term inflation nearing the 4% target rate, and further rate cuts by global central banks strengthening the case for a December cut. The shift to a neutral stance has a positive impact on liquidity, allowing the RBI to be more supportive of growth and respond swiftly to liquidity deficits. It also increases tolerance for overnight rates staying within the Standing Deposit Facility (SDF) and the repo rate.
However, several factors could alter the trajectory of rate cuts. Escalation of the Middle East conflict and the Ukraine war could negatively impact markets and drive up oil prices, despite weak Chinese demand. A large fiscal stimulus by China could also push commodity prices higher and potentially trigger foreign portfolio investor (FPI) outflows from India. Additionally, the US presidential elections and economic policy could influence global growth and markets. The RBI has positioned itself with a neutral stance, providing it with the flexibility to respond to changes in the growth-inflation mix.
Source: Neutral stance gives RBI freedom for managing liquidity