Repo rate status quo shows RBI's continued focus on inflation over growth

Monetary policy support to growth will be limited

Official estimates released recently showed that the Indian economy was growing significantly slower than the rate projected by the Reserve Bank of India (RBI). The economy expanded 5.4 per cent in the second quarter this financial year as against the RBI’s projection of 7 per cent for the same period in its October monetary-policy review. Some analysts have argued that the delay in policy-rate reduction by the Monetary Policy Committee (MPC) was partly responsible for the loss of momentum. Top government functionaries also argued for lower policy interest rates in recent weeks. Given the backdrop, the MPC did well to keep the repo rate unchanged last week. A knee-jerk reaction at this stage would not have helped. Completing the disinflation process remains important.

 

Yet, the RBI reduced the cash reserve ratio (CRR) by 50 basis points, which will come into effect in two tranches and increase liquidity worth Rs 1.16 trillion in the banking system. Although the RBI has justified the cut, anticipating liquidity stress, other tools are available with the central bank to fine-tune temporary liquidity conditions. The CRR cut is essentially a step in normalising monetary-policy operations. Although the inflation rate went above the upper end of the tolerance band in October, it is now projected to decline to the mandated target of 4 per cent by the second quarter of 2025-26. The latest Monetary Policy Report (released in October) shows the RBI expects the inflation rate to be at 4.1 per cent in the fourth quarter of 2025-26. Thus, inflation outcomes in 2025-26 are likely to be close to the 4 per cent target and would open up space for policy-rate reduction.

 

However, the extent and timing will depend on various factors. For instance, it’s worth noting that the inflation outcomes have surprised the central bank over the past few years on the upside. Thus, ideally, the MPC would need to make sure that the inflation rate will remain aligned with the target on a durable basis. Further, recent research by RBI economists showed the estimate for the neutral rate in the fourth quarter last financial year was 1.4-1.9 per cent compared to 0.8-1 per cent in the third quarter of 2021-22. Thus, given the increase, the scope for policy-rate cuts will be fairly limited, which will also play a role in determining the appropriate time to deliver the cuts. The MPC may be reluctant to frontload the rate cut and want to save some policy space to deal with uncertainties.

 

In terms of growth, while the MPC has reduced the growth projection for this financial year to 6.6 per cent compared to 7.2 per cent in the last policy meeting, its projection for the next four quarters, including the ongoing quarter, on average, is above 7 per cent. Clearly, the MPC expects momentum to improve though the projections may appear optimistic to some analysts. In any case, the limited space for policy-rate cuts may not do much to push up economic growth in a sustainable manner. The government will need to look for other drivers to increase the growth rate. In an unrelated move, the RBI increased the interest-rate ceiling on foreign currency non-resident bank deposits. Although foreign capital has moved out in recent months, the decision is somewhat intriguing, given the current levels of foreign-exchange reserves. In fact, the rupee, which is overvalued in real terms, should be allowed to depreciate.