The Elephant in the Room Should Retreat to the Jungle Again

The Monetary Policy Committee of the RBI has left the policy rates unchanged, with the Repo Rate at 6.50%. The rationale for the status quo on rates is given in the policy statement – “Headline inflation has come off the December peak; however, food price pressures have been interrupting the ongoing disinflation process, posing challenges for the final descent of inflation to the target.” RBI has highlighted the volatility on food prices as an impediment to attaining the inflation targets. However, the overall assessment is that inflation is moderating and aligning itself with the targets.

The inflation forecast for FY25 has placed the estimated retail inflation for the year at 4.50%, with Q1 estimate at 4.90% lower from the earlier estimate of 5.00%. The Q2 and Q3 estimates are at 3.80% and 3.60% respectively, indicating the possibility of a decline in inflation over the next two quarters, though in Q4 it is still expected to be at 4.50%. Food inflation is expected to moderate with a record Rabi crop especially in wheat, and near normal monsoon forecasts. But there could be some pressure on vegetable prices emanating from above normal summer temperatures in the April-June period. As the Policy Statement states, “Unpredictable supply side shocks from adverse climate events and their impact on agricultural production as also geo-political tensions and spillovers to trade and commodity markets add uncertainties to the outlook.” The GDP growth estimate for FY25 is placed at 7.00%, and the outlook for economic growth remains robust.

The liquidity conditions eased as a result of RBI operations in the money market, government spending, and the reversal of the sell-buy swap in Dollar-Rupee. RBI has been pro-actively supplying liquidity to the markets based on the prevailing money market conditions.

The policy may have very marginal implications for the markets and portfolios. The short-term money market yields will be governed by the liquidity conditions, and the long end yields may move up or down by a few basis points, but nothing very significant. The forecast of lower inflationary expectations, the robust inflows into government bonds from overseas investors, the lower primary issues, and the likelihood of a rate cut during Q1/Q2 from both RBI and the Fed are likely to influence the basic trend in market yields. Our recommendation on gilt funds remains unchanged.

The RBI Governor while announcing the policy cited the interesting analogy of the elephant in the room. In this regard the governor’s statement mentioned, “Two years ago, around this time, when CPI inflation had peaked at 7.8 per cent in April 2022, the elephant in the room was inflation. The elephant has now gone out for a walk and appears to be returning to the forest.” Inflationary pressures must abate a little more before policy rates could come down. But the market rates could move down ahead of the RBI rate action.

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