A decision by the Monetary Policy Committee (MPC) to leave the repo rate unchanged would have been difficult. It is difficult to choose between rising inflation and a sudden slowdown in economic growth. Although the MPC has cut the cash reserve ratio (CRR) this time, we expect it to go further and take a stab at the repo rate at its next policy review meeting in February.
For 21 months now, the MPC has kept rates unchanged. It awaits a sustained easing in consumer price index (CPI)-based inflation. Gage is under pressure due to food prices. Over the past three months, headline CPI inflation has been rising, breaching the upper limit of the MPC’s 4-6 percent tolerance band in October.
To complicate matters, India’s growth is slowing. For July-September 2024, the country registered GDP growth of 5.4 percent, the lowest in seven quarters. While the second half should see a pick-up, a sharp decline in the second quarter has prompted the RBI to revise its GDP growth forecast for the current financial year from 7.2 percent to 6.6 percent. Last fiscal year, the MPC could focus on inflation as GDP growth was a solid 8.2 percent. But the recent slowdown has increased the tradeoff with inflation. CRR reduction is an incremental step to support growth as it increases systemic liquidity. Favorable conditions in financial markets should support economic growth.
Monetary policies in major economies have become less restrictive in recent days. The US Fed and the European Central Bank ECB each cut rates by 75 basis points (bps) in 2024. But the pace of rate hikes has been slower than expected as inflation is proving difficult for them too. The Fed’s path to further rate cuts is unclear as incoming President Donald Trump talks about imposing higher tariffs, which could add to inflationary pressures. S&P Global sees fewer rate cuts by the Fed in 2025 than expected three months ago.
While most emerging market central banks are likely to cut rates in 2025, they will monitor the impact of policy changes in the US on their growth and financial markets. Put another way, the global environment is favorable for rate cuts, but their pace will be slow.
The MPC’s cautious stance stems from trends in the domestic economy, particularly as food prices remain stubbornly high. Despite a good monsoon, retail food inflation has averaged 8.3 percent this fiscal till October. That’s a good 170 basis points (bps) high over the year.
True, retail inflation excluding food has been much lower — at 2.5 percent in April-October, down a good 150 bps year-on-year. But it is food prices that generally dictate the pace of retail inflation in India, given its significant weighting in the CPI index. Food prices also have the biggest impact on the cost of living. The higher they go, the bigger the hole in the budget of low-income households.
We estimate effective inflation in rural areas to be 5.4 percent for the bottom 20 percent of households (based on income) and 5.1 percent for the top 20 percent in April-October 2024. It was 4.6 percent in urban areas. 4.2 percent for the bottom 20 percent and 4.2 percent for the top 20 percent.
Food inflation has been rising above 6 percent on an average for almost three years. This has cumulatively and materially increased the average monthly food bill of the household. CRISIL Research estimates that the monthly cost of an average vegetarian thali increased by 20 percent in October, while the price of a non-vegetarian thali increased by 5 percent. Although there is a slight drop in November, it remains high.
Since food items are purchased frequently, consumers’ inflation expectations are quickly affected by changes in their prices. Some foods are also important inputs for sectors such as fast-moving consumer goods (FMCG) and restaurants. Therefore, an increase in their prices adds cost pressure to such businesses. In general, they try to pass it on to consumers, adding to overall inflation. Rising food bills also contributed to slowing consumption in the second quarter. Major FMCG companies have repeatedly pointed this out.
In the last two years, with the increase in food inflation, there has been a decrease in private consumption. It briefly reached 7.4 percent in the first quarter of last financial year, but fell to 6 percent in the second quarter. The urban economy faces additional headwinds from low borrowing and rising interest rates. On the other hand, the rural economy seems to be in good condition as the agricultural production is expected to be better than last financial year after another normal monsoon. Therefore, as demand drivers shift from urban to rural, food inflation has become a pain point.
A healthy agricultural output this year could moderate food inflation in the second half. When vegetables arrive in the market in Rabi or winter, the price of vegetables drops sharply. Non-food inflation is expected to moderate as non-food prices remain stable. All this could prompt the MPC to begin cutting rates at a review meeting in February. It said, cumulative cuts in the next cut cycle will be less than 250 basis points higher after May 2022 as domestic growth momentum is expected to remain healthy and the global rate cut cycle will also ease.
Given that food prices influence the retail inflation gauge, a new CPI series based on the latest consumption survey may help reassess the importance of food in shaping monetary policy decisions. Such recalibration will reduce the weight given to food in the CPI basket. Fiscal policy needs to intensify efforts to limit the structural and climate risks of food prices to headline inflation.
Inflation has become a concern for the Indian economy. RBI cannot ignore this as price stability is its main mandate. A fiscal policy that mitigates supply risks can help the RBI to sustainably reduce food inflation and balance inflation with the growth objective.
Joshi is the Chief Economist and Tandon is the Senior Economist at Crisil Limited