Easing inflation kindles February rate cut hopes

The Indian economy has begun to hum again in the December quarter as signalled by key activities after moderating in the second fiscal quarter, and inflation is forecast to average below the targeted 4% next fiscal year, said the latest monthly report on the economy by the Reserve Bank of India (RBI).

The economy is likely to expand at 6.7% next fiscal year and inflation may average 3.8%, providing room for the Monetary Policy Committee (MPC) to reduce key policy rate at its next meeting in February.

"High frequency indicators (HFIs) for the third quarter of 2024-25 indicate that the Indian economy is recovering from a moderation in momentum witnessed in Q2, driven by strong festival activity and a sustained upswing in rural demand,'' said the central bank's State of the Economy by its research department.

To be sure, the RBI maintains the views contained in the report do not necessarily represent its own opinion.

India's economic growth fell to a seven-quarter low in September at 5.4% triggering calls for a reduction in interest rates to get the momentum back. But the central bank, mandated to target inflation as measured by the Consumer Price Index at 4% in a two percentage point band, maintained status quo citing inflation which was above its upper band of 6%.

The debate has been raging that the central bank needs to look beyond food prices which have a weighting of more than 40% in the index, but the RBI has been steadfast in saying that it would be foolish to strip food out of the CPI target. So much so, the last MPC meet saw two of the six members dissenting in favour of a rate cut.

But the RBI's assessment of data shows that economic activity has been improving after a blip.

"E-way bills increased by 16.3% on year in volume terms in November. Toll collections recorded double-digit growth in November 2024, both in value and volume terms,'' the report said.

It is not just the economic activity which is accelerating, but the keenly monitored employment generation is also showing signs of improvement and breaking records.

"Employment in the organised manufacturing sector witnessed an expansion for the ninth consecutive month as per the PMI," the report said. "The rate of job creation in the services sector expanded at the fastest pace since the survey's inception," which was in 2005.

The central bank researchers also highlighted the complications arising from the consumer behaviour on macroeconomic variables and the limitations of the conventional economic models to come up with apt policy prescriptions.

"These shifts in consumer behaviour may require central banks and policymakers to transition from traditional macroeconomic models to agent-based modelling, integration of behavioural economics, nowcasting, policy simulations and advanced liquidity stress tests," said the report. "They also need to equip themselves with cutting-edge computational tools like machine learning and big data analytics."

The researchers also said that one of the most commonly used benchmarks - the natural rate of interest rate - the rate that reflects the real interest rate that supports the economy at full employment while keeping inflation low and stable - has also undergone changes making rate decisions difficult.

"A better understanding of the reasons behind the post-pandemic reversal and this recent disconnect from history will be useful for monetary policy setting in an uncertain future. Global economic conditions add complexity to an accurate assessment of R-star,'' it said . R-star is the natural rate of interest.