RBI joins other central banks to dislodge market complacency

Structurally, the rational expectations sentiment of the markets, which factors in perfect information between the central bank and economic agents, is seen to be counterproductive and ineffective. The recent Fed chair Jerome Powell’s interview also talked about it and so has the RBI as it believes that leaving room for adaptive expectations, that accommodate progressive adjustments to uncertainties, may improve the efficacy of monetary policy actions.

On the inflation front, core inflation continues to remain a cause of concern not just for the RBI but for the global central bankers. In their recent monetary policy meeting, the Fed and the ECB have conveyed their uneasiness with the sticky and elevated core inflation.

Even though the headline inflation for India has been trending below the RBI’s upper tolerance band since November 2022, visibility of any signs of disinflation in core evades. Also, given the seasonal nature of the decline in food inflation, led by a contraction in vegetable prices, we believe that once this seasonal impact wanes off, the headline inflation would not have a supportive tailwind.

RBI’s upward revision of its 1HFY24 growth projections to 7% from 6.5% projected during the last meeting is rather optimistic and could be revised downwards. General optimism in the rural recovery conditional upon higher rabi harvest is somewhat misplaced as a dry spell during the winter season would likely have a negative impact on the cost of cultivation and the quality of the product.

Even though the IMF has revised its global growth outlook upwards by 20 bps to 2.9%, it remains lower than the historical (2000-19) annual average of 3.8%. Importantly, world trade volume growth is expected to decline in 2023. Weak external demand and an uncertain global environment remain a drag on the overall growth prospects. India’s growth sensitivity to global trade at 1.73x since 2017, accentuates a larger multiplier impact of a fragile global growth outlook on domestic growth.

Factoring in the a) continued affirmation of the Fed’s tightening path and b) the Indian rupee (INR/USD) sensitivity to slackening growth, narrow interest rate spreads, overvaluation, and weak portfolio flows, we anticipate renewed weakening in INR/USD.The real policy rate for the US at 0.1% and 0.3% for India (repo rate-core inflation), remain accommodative in the context of their objectives of price stability. The narrowing India-US real rate can create external sector volatility, in the form of sharp rupee depreciation. Therefore, even if we consider RBI’s inflation projection of 5.3% for FY24, the real rate should be at least 2%, which is how we have arrived at our estimates of India’s terminal rate to be above 7%.

This disjunction of the India-US growth differential and the narrowing India-US real interest rate differential will accentuate as the US Fed rate increases towards the guided 5% mark and 1.6% in real terms. This will necessitate adequate readjustments by the RBI as well.

The reinforcing stance of central banks that the war against inflation is not over yet and that they are still accommodative runs contrary to the market’s positioning of the Fed pivot as early as the second half of 2023 and the end of the rate hike cycle in India. Thus, as the markets reset their expectations it will necessitate an unwinding of the now entrenched “early pivot trade” across different asset classes.

How will RBI’s normalization impact corporate performance?
First, the tightening liquidity will intensify the scurry for term deposits by banks and higher rates will temper credit growth. This will eventually impact their margins.

Second, consistent hardening of lending rates would increase the interest cost for the non-finance companies, thereby extending the decline in profits amid sustained margin pressures. The contraction of profits will lead to either 1) an increase in output prices, 2) a scaling down of sales growth, or 3) a mix of both.

Hence, as the RBI eventually moves from the extant “removal of accommodation” stance towards a “tightening” stance, growth will decelerate; in the current scenario, it is unlikely that inflation will edge toward RBI’s central target of 4% without a slowdown in growth, both for the economy and the banking sector credit.

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