Monetary policy: RBI faces Hobson's choice on policy rate cut decision

This policy comes at a time when growth is slowing, inflation is still pretty high, and the rupee has started losing value against the dollar

In the first week of November, the US Federal Reserve cut its benchmark interest rate by 25 basis points to 4.5-4.75 per cent, its lowest level since March 2023. In a unanimous vote, the Fed's policy committee went for a second successive cut in the current cycle. One basis point is a hundredth of a percentage point.

 

Fed’s two rate cuts so far this year have reduced the federal funds rate by a combined 75 basis points.

 

Analysts say that the larger impact will be felt if the Fed continues to cut rates in its December meeting and into 2025. Going by the CEM FedWatch prediction, the chance of Fed cutting rate at its December 18 meeting is 60 per cent. If that happens, at 4.25-4.5 per cent, the rate will be 1 percentage point below its recent high.

 

The CMD FedWatch is a tool which analyses 30-day Fed fund futures pricing data to calculate the probability of a change in the rate.

 

In November, as expected, the Bank of England also announced its second rate cut to 4.75 per cent. Its monetary policy committee voted eight to one in favour of reducing the policy rate.

 

The European Central Bank (ECB) has lowered interest rates three times this year, taking borrowing costs down to 3.25 per cent. It is widely expected to make another 25-basis-point cut in December and further gradual reductions next year. Analysts expect that the ECB’s key deposit rate will be lowered to about 2 per cent by mid-2025. The last rate cut took place in October – the first instance of back-to-back cuts in 13 years.

 

Choosing between food and Fed, the Reserve Bank of India (RBI), in its last policy in October, preferred to fight inflation, driven by food prices, and not toe the line of the Fed. It also pointed out the growing divergence in inflation-growth dynamics across countries.

 

Till the release last Friday of the gross domestic product (GDP) data for the second quarter of FY25, the inflation-growth dynamics in India were not in favour of a rate cut. But things have changed dramatically with the Indian GDP growing at 5.4 per cent in the quarter ended September 2024, significantly below the consensus forecast of 6.5 per cent. This is the lowest print in seven quarters and much lower than 6.7 per cent growth in the previous quarter.

 

The gross value added (GVA), an economic productivity metric and a better measure of growth, was also much lower at 5.6 per cent in the second quarter, against the consensus forecast of 6.3 per cent.

 

In the growth-inflation dynamics, the balance has suddenly tilted in favour of supporting growth. So, the RBI should cut the rate. Well, it’s not that simple; the ground reality is quite complicated. While there is a substantial slowdown in growth, inflation is still pretty high too — above the RBI’s flexible target — and the rupee has started losing its value against the US dollar.

 

Theoretically, when the Fed raises the rate, there is pressure on the RBI to follow suit, but when it cuts the rate, the Indian central bank doesn’t need to act. Why? The Fed rate cut widens the interest rate differential between the Fed and RBI and helps stem the outflow of money from India and manage the rupee’s value vis-à-vis the US dollar.

 

But slowdown in growth and high inflation when the rupee is weakening against the dollar have made this policy tough for the RBI.

 

In October, the RBI’s newly constituted monetary policy committee (MPC) kept the repo rate, or the rate at which the Indian central bank lends money to commercial banks, unchanged at 6.5 per cent, but changed its stance from “withdrawal of accommodation” to “neutral”.

 

The change in stance signalled a change in the direction of the Indian central bank’s approach to the policy. Or, so we thought. But in his subsequent public appearances, RBI Governor Shaktikanta Das has made it clear that nothing has changed, and that the neutral stance doesn’t mean much. He has also been quite bullish on the growth front.

 

Ahead of the October meeting, India’s retail inflation had softened significantly in July and August – to 3.6 per cent and 3.65 per cent, respectively, and below the RBI’s flexible inflation target of 4 per cent (with a two-percentage-point band on either side).

 

Since then, the inflation trajectory has changed. The rise in inflation was expected, but the sharpness with which it rose in October was not in sync with expectations. Consumer Price Index (CPI)-based inflation jumped to a 14-month high of 6.21 per cent year-on-year in October, from 5.49 per cent in September. Food inflation rose to a 15-month high of 10.9 per cent, from 9.2 per cent in September, while core or non-food, non-oil inflation rose to an 11-month high of 3.8 per cent, from 3.6 per cent in September.

 

In its October policy, the RBI projected 4.8 per cent inflation in the December quarter, 4.2 per cent in the March quarter, and 4.5 per cent for the full year financial year, with “risks evenly balanced”. Indeed, CPI-based inflation will fall below 5 per cent in the March quarter, driven by moderation in food inflation, but in the December quarter it could be between 5.5 per cent and 6 per cent and, for the full year, between 4.7 per cent and 4.9 per cent, overshooting the RBI estimate.

 

In the same policy, the RBI was emphatic that the Indian growth story remained intact, as its fundamental drivers – consumption and investment demand – had been gaining momentum. It found the prospects of private consumption bright on the back of improved agricultural outlook and rural demand, even as the government expenditure by the Centre and states was expected to pick up pace after elections.

 

Its estimate for 2024-25 real GDP growth is 7.2 per cent – with 7 per cent growth in the September quarter and 7.4 per cent each in the December and March quarters. The real GDP growth rate for the June quarter of 2025-26 is projected at 7.3 per cent, with risks “evenly balanced”.

 

Even though growth is set to pick up in the second half of FY25, it’s certain that the RBI will pare down its GDP projection for 2024-25. Analysts’ expectations for GDP growth range between 6 per cent and 6.5 per cent. The RBI may also revise its inflation projection upwards.

 

Now, the key question: Will the RBI cut the policy rate this week?

 

It's Hobson's choice before the central bank. If it cuts the rate, the alarm bell will ring on the growth front, which is uncalled for, particularly when growth will look up in subsequent quarters. Besides, inflation is still pretty high.

 

Should it then cut the cash reserve ratio (CRR) or the money that commercial banks keep with the RBI to release liquidity? The liquidity in the system is tight and the weighted average rate of the call money market these days is higher than the repo rate. The RBI has been selling dollars to arrest a sharp fall in the local currency. For every dollar it sells, an equivalent amount of rupee gets sucked out of the system, impacting liquidity.

 

Besides, a rate cut without liquidity infusion doesn’t make any sense as that will hurt banks the most.

 

The best way of managing this trilemma for the RBI could be opting for open-market operations (OMO) – buying government bonds from banks in phases to manage the liquidity for now. It can go for a rate cut at the next MPC meeting in February, as inflation will have started trending downwards by that time.

 

Despite a sharp fall in GDP growth, the RBI is unlikely to go for a rate cut on Friday. More than action, the market will keenly watch how the RBI communicates. Leaving aside the Covid pandemic period, this is the toughest policy for Mr Das, whose current term will end less than a week after the policy announcement.

 

The writer is an author and senior advisor to Jana Small Finance Bank Ltd.  His latest book: Roller Coaster: An Affair with Banking. To read his previous columns, please log on to www.bankerstrust.in 

 

X: @TamalBandyo