Real interest rates need to climb before RBI's easing cycle begins

The primary reason behind such overwhelmingly short odds on the 'higher-for-longer' rate trajectory is the nature of the ongoing economic expansion, which has made New Delhi a distinct outlier in a rather circumspect world. For more than 30 straight months, the gauges for purchasing managers have stayed in the expansionary mode, while the percolation effects of unprecedented capital expenditure in helping broad-base the texture of economic growth is becoming increasingly evident.

"Expectations for a fresh round of capex by the corporate sector to take the baton from the government and fuel the next leg of growth are mounting," said the central bank bulletin for February. "Balance sheets are healthy on the back of high profits, with leverage remaining constant or improving and the return ratio at a multi-year high."

The durability of a phase of growth anchored in the addition of fresh capacity is well credentialed from the 2002-2007 expansionary cycle when India first began to pour money into rebuilding its then rickety public infrastructure and fuel a boom in industries as diverse as telecom, surface and maritime transport, mining, metals, aviation, and consumer discretionary industries.

In recent years, the pace of capital expenditure, led initially by the government, has quickened and become more secular, drawing inevitable parallels with the previous cycle during which the benchmark Sensitive Index surged seven times in a seemingly unidirectional bull run - ultimately ended by the subprime crisis.

Real Neutral Rate
During the last such cycle, according to a Morgan Stanley study, the real neutral rate remained closer to 200 basis points, indicating a central bank rate action might have to wait.

One basis point is a hundredth of a percentage point.

"We highlight risks of a potential delay and/or risk of no easing driven by better-than-expected trends in growth, capex and productivity. which will imply higher neutral real rates," Morgan Stanley said in a note to its clients while highlighting it now expects a rate decision only in the third quarter of this calendar year.

With private consumption returning to pre-pandemic levels and rural demand expected to catch up after a couple of years of evident lag, the impact of capex-led growth on policymaking will likely become more prominent. The Morgan Stanley study traces the real rates - currently below 150 basis points - to as far back as two decades to include a period that coincides with the previous major capex cycle.

It notes higher policymaker tolerance for real rates than they now are, indicating a wider spread for the real rates in the current cycle before any monetary easing is possible.

"Higher growth, driven by improving productivity, could warrant higher neutral real rates versus our base case of 150 basis points... We believe that the current cycle is similar to the 2003-07 cycle, given growth was driven by capex and productivity," said the Morgan Stanley report. "The average real policy rate averaged 190 bps in that cycle."

That means the much-awaited cycle of rate easing could well be delayed - and may not last long enough.