Moderating food inflation, tighter liquidity conditions, financial market volatility, and a noticeable slowdown in India’s growth pace will all be factors in this week’s monetary policy meeting. According to the First Advance Estimate (FAE), GDP growth will decrease to 6.4% in FY25 from 8.2% in FY24. High-frequency indications point to a moderating demand for urban consumption, and investment growth has been slowing. With profitability declining in the first quarter of FY25 and early Q3 FY25 figures indicating a mixed picture, corporate performance has been lackluster. In addition, the persistent geopolitical tensions and policy uncertainty following the US elections continue to make the global environment insecure. On the plus side, meanwhile, domestic inflationary pressures have decreased recently due to a decline in food costs. The forecast for future food inflation is improved by robust Kharif production and successful rabi sowing.
Amidst these macroeconomic conditions, the MPC’s focus is expected to shift from concerns over high inflation to supporting economic growth. Therefore, we anticipate that the MPC will reduce the policy rate by 25 bps in the upcoming meeting while retaining a neutral stance. Markets will be closely monitoring the statement of the newly appointed governor of the RBI, and we expect the policy statement to have a dovish undertone even while remaining cautious on the global front. We anticipate that the RBI could revise its growth projections of 6.6% for FY25 marginally downwards to bring it in line with the FAE. Inflation projection is be revised up from 4.5% to 4.8%.
Furthermore, the policy statement is likely to focus on liquidity management as liquidity conditions has remained tight with money markets rates remaining elevated. Strong FII outflows and the RBI’s intervention to cushion the impact on exchange rate have resulted in a fall in durable liquidity.
Growth Concerns to Dominate MPC Agenda
In Q2 FY25, GDP growth moderated to 5.4%, down from 8.1% during the same period last year, primarily due to disruptions associated with the election period and adverse weather conditions (Refer Exhibit 1). As a result, the growth forecast for FY25 is now 6.4% (FAE). A key concern arises from the slowdown in investment growth and challenges to urban consumption demand. Despite disruptions that induced moderation in investments in the year’s first half, a continued slowdown in investment growth is also anticipated in the second half. Investment growth for H2 FY25 is projected at 6.4%, a decline from the average growth of ~8% growth observed in H2 FY24 and around the same levels as in H1 FY25.
Our analysis (click here) reveals a contraction in corporate profitability during H1 FY25. Early corporate results for Q3 FY25 remain mixed, with key FMCG players expressing concerns over weakening urban consumption demand. Although the rationalisation of income tax slabs in the Union Budget is expected to provide some relief in the coming year, short-term challenges continue to prevail.
High-frequency indicators present a mixed outlook on economic momentum. Average growth in passenger car sales (25.5% in Q3 FY24 vs 5% in Q3 FY25), two-wheeler sales (22.5% vs 1.4%), E-way bill (17.4% vs 16.9%) and retail credit (29.3% vs 12.7%) have moderated in Q3 FY25 compared to the same period last year. On the other hand, average growth in petrol consumption (1.3% in Q3 FY24 vs 4.9% in Q3 FY25) and diesel consumption (4.8% vs 9.7%) and domestic air passenger traffic (9.2% vs 11.2%) have shown some improvement in Q3 FY25 compared to the same period last year.
The below-potential GDP growth will likely continue into FY26, with the latest Economic Survey projecting 6.3% to 6.8% growth in FY26. However, our forecast is at the higher end of this range, at 6.7%.
Moderating Inflation to Give Some Comfort to MPC
In December, the CPI inflation moderated to 5.2% from 5.5% in November, primarily due to a slowdown in food inflation. The inflation rate for vegetables continued to ease, dropping to 26.6% in December from 29.4% in November. The arrival of fresh harvests has led to a seasonal correction in food prices. Good Kharif production has brightened the outlook of the inflationary environment along with good progress of rabi sowing.
As of the third week of January, rabi sowing of food grain has increased by approximately 3% YoY, driven primarily by a 3.3% rise in cereals and a 2.3% increase in pulses. Favourable climatic conditions and healthy reservoir levels across the country have supported this positive trend. As of January end, nationwide reservoir levels stood at 64% of full capacity, 16% above the long-term average. Heathly reservoir levels would also provide the essential cushion for Kharif sowing if the monsoon lags next year. However, rabi sowing of major oilseeds has declined by around 4.2%, raising concerns. Given the country’s reliance on edible oil imports, it will be crucial to closely monitor inflation in this category, especially considering high global edible oil prices and the recent increase in customs duty. As highlighted by the Economic Survey, it will also be essential to closely monitor weather-related disruptions, such as heatwaves, whose frequency has increased in recent years.
Core inflation as well as WPI has remained benign so far averaging just 3.4% and 2% in the past six months respectively. Eventhough WPI inflation is expected to remain at comfortable levels, we expect it to inch up marginally as the favourable base effect wanes. Just by only excluding vegetables, the CPI inflation stands at 3.9%, well below the RBI’s target of 4%. This supports the case for a potential rate cut. While the recent depreciation of the rupee could exert pressure via imported inflation, the relatively low core inflation should help mitigate any significant concerns.
We anticipate that headline inflation will fall below 5% in Q4 FY25, driven by a moderation in food inflation (Refer to Exhibit 2). We expect inflation to average 4.8% and 4.5% in FY25 and FY26 respectively. We expect the MPC to revise up its inflation projections to 4.8% from 4.5% for FY25.
Liquidity Management to Remain in Focus
In addition to the policy rate cuts, the governor’s statement is expected to focus on liquidity management. Systemic liquidity has remained in deficit during December and January, leading to the weighted average call rate hovering near or above the MSF rate for specific periods over these months. Despite the CRR cut leading to an infusion of Rs 1.2 trillion in the December policy meeting, the systemic liquidity deficit has averaged Rs 650 billion and Rs 2 trillion in December and January, respectively (Refer Exhibit 3). Increased forex interventions, reflected in the decline in foreign exchange reserves and seasonal fluctuations in currency circulation, have impacted liquidity conditions (Refer to Exhibit 4). The government’s cash balances have been volatile as well. To address these liquidity concerns, the RBI has taken measures such as increasing tenor and amount of variable rate repo (VRR) auctions, currency swap auctions, and OMO purchases (Refer Exhibit 5).
We do not expect any further reduction in the CRR rates as they were brought to pre-pandemic levels in the last policy meeting. However, RBI will continue to use tools such as OMO purchases and VRR auctions of higher tenor/quantum to address the liquidity concerns. An uptick in government expenditure will also result in easing money market conditions as liquidity deficit stands close to Rs 2 trillion as of the last week of January. We expect that the RBI will continue to remain nimble and flexible in its liquidity management, ensuring favourable money market conditions. The RBI will continue to ensure ample liquidity is available to support the credit demand.
External Volatility and Pressure on Rupee Remain High
The current volatility in the financial markets, uncertainty about trade policy, and ongoing geopolitical risks have kept the external environment uncertain. Sustained FPI outflows and strengthening of the dollar index amid falling interest rate differential with the US have accentuated pressure on the Indian rupee. US 10Y yield has risen by 75 bps since Oct-24, driven by expectations of fewer Fed rate cuts amid strong US growth and likely inflationary policies under the new administration. In contrast, the Indian 10Y yield has declined by 7 bps during the same period, supported by moderating inflation and expectations of RBI rate cuts. As a result, the interest differential with the US has fallen sharply. Since October, net FPI outflow stands at USD 21 billion.
Recent data indicates that the RBI has taken a calibrated approach to loosen its control over the rupee, resulting in a gradual depreciation against the US dollar. Since this shift in strategy, forex reserve levels have stabilized after a continuous decline since early October. The RBI’s foreign exchange reserves have decreased by approximately USD 72 billion since October, reaching USD 630 billion by the end of January.
Forex reserves remain sufficient despite the recent fall, covering ~8 months of imports. India’s current account deficit remains comfortable with CAD, projected at 0.9% of GDP in FY25. Going forward, monitoring the implementation of the trade and fiscal policies under the new administration in the US will be crucial, as these will play a key role in shaping market dynamics. Geopolitical risks also remain a key monitorable amidst the ongoing war in Ukraine and the Middle East. Risks of a trade war remain elevated, with the US recently sanctioning key neighboring countries and China. This could adversely affect global trade and India’s CAD in FY26.
Way Forward
With growth concerns escalating and domestic inflation easing, we expect the MPC to cut the policy rate by 25 bps in the upcoming meeting. However, the RBI will remain watchful of the global uncertainties and their impact on Indian economy. The global trade war will have adverse implications for India’s growth, inflation and trade dynamics. However, there is still a lack of clarity on the extent of this impact. Sharp FII outflows and rupee weakening have further complicated the task for RBI. However, we feel there is a higher probability that RBI will initiate a cautious rate-cutting cycle, taking comfort from easing food inflation. A further rate cut of 25-50 bps is possible in FY26, depending on how growth-inflation dynamics play out. Global factors and their implications for the domestic economy will be critical for the RBI in FY26.