A bimonthly meeting of the Monetary Policy Committee will take place later this week, and expectations are for some shift in policy stance to make it more accommodative and, preferably, a rate cut. There are five main reasons for this expectation.

First, after a robust GDP growth in the first half of 2023-24, there is likelihood of a moderation of around 50 basis points (bps) in growth in the second half. In 2024-25, growth is expected to remain in the 6.5-7 per cent range. Though this is robust growth, acceleration is missing. And, further, there still isn’t any visible upsurge in capital formation, which is stuck at around 31 per cent. With an Incremental Capital Output Ratio (ICOR) during 2011-2023 averaging over 6, the long-term growth prospects are likely to get constrained due to investment deficit.

Second, there is inverse yield curve. The short-term rate of return on T-bills is higher than on long term securities, though the 5-10-year yield curve is normal. It shows that the stress on short-term yields continues.

Third, the liquidity deficit has persisted for nearly six months.

View and counter-view

Fourth, there has also been the issue of the dated base of Consumer Price Index (CPI), which is more than a decade old and inadequate incorporation of free ration under the National Food Security Act. This could be showing higher inflation than what is probably being faced by consumers, particularly at the lower end of income.

Fifth, the divergence between producers’ price index as captured by the Wholesale Price Index and CPI enables realisation of higher profit or economic rent seeking by producers. There are clear evidences of strengthening of profit margins across all segments. Within WPI also, we observe a clear wedge between inflation of basic goods and intermediates on the one hand and consumer goods, both durable and non durable, on the other.

In the last nine months since March 2023, while basic and intermediate goods have witnessed a deflation averaging 3.6 per cent, consumer goods had a positive inflation of 1.4 per cent indicating a whopping gap of 5 percentage points in inflation rates. All these factors could suggest that the fiscal policy must act, rather than persist with a hawkish monetary stand. There is no denying these factors suggest moderation in monetary policy, but it is important to look at the counter-view.

First, there has been a significant decline in capital intensity of the economy resulting in ICOR moderating to an average of 4 in the last three years post Covid. In 2022-2024, ICOR was 4.3. If this trend persists, then a GCF/GDP ratio of 31-32 per cent is enough to get the required growth rate of 7-7.5 per cent. However, low ICOR is a short-term phenomenon because both manufacturing and services, which are the promising sectors, have a much higher ICOR. Further, low ICOR post pandemic is also on account of excess capacity.

Second, the capacity utilisation has continued to be sticky at 70-75 per cent post Covid indicating that in traditional demand driven sectors there is yet additional utilisable capacity. Though in a period of reducing shelf life of a product, capacity utilisation cannot be expected to increase in a big way, but as of now there is some space particularly because utilisation had dipped to 45 per cent in Q1 of 2020-21.

Credit growth

Third, the credit growth, which had remained muted until December 2021, started surpassing the deposit growth since then. Credit growth was hovering around 15 per cent surpassing deposit growth by a margin of around 6 per cent. With SLR and CRR together at 23 per cent, 77 per cent of deposits were available for credit.

The small and medium enterprise (SME) segment also exhibited significant activity in the current financial year expecting a near 100 per cent increase and to that extent countering the pre-emption view.

Fourth, the liquidity deficit. The RBI will do VRRR operations to overcome this and the government is likely to spend now, as uncertainty in their minds on nominal growth winds down.

Fifth, and the most important, is the dated base of CPI, which is not overestimating inflation. We have tried to use 2019-20 personal consumption data from National Accounts, adjusted for the consumption data of NSSO survey 2011-12.

It is observed that the two series move almost parallel, with food inflation in the new base being slightly higher than the one at the old base because of inter commodity changes in weights. Overall, inflation with new base in the last two months at 6.1 per cent seems to be running above the upper threshold of the RBI benchmark inflation of 6 per cent (see Chart)

Sixth, corporate profitability has indeed shown an improvement, but that enables them to compensate for the likely moderation in government capex.

On balance, therefore, we consider a status quo in monetary policy in the forthcoming meeting of MPC with policy rates being retained at their current levels till August 2024.

Gopalan is former Secretary, Economic Affairs, and Singhi is former Senior Economic Adviser, Ministry of Finance. Views are personal