The ‘impossible trinity’ states that a central bank can pursue only two out of three policy options simultaneously—a fixed exchange rate, free capital movement, and independent monetary policy. Among developed market (DM) central banks the policy choices are—independent monetary policy, free capital movement, and accepting higher exchange rate volatility. Inflation in the US surprised on the upside in Q1 2024, increasing the chances of the Fed remaining on pause for longer. Growth conditions in other DMs are significantly weaker, forcing central banks to diverge from the Fed.
We are already beginning to see monetary policy divergence in the DM space with the Swiss National Bank and Riksbank cutting interest rate to support growth and resulting in currency depreciation. The European Central Bank (ECB) has indicated that interest rate could be cut as soon as June, with inflation expected to move towards target levels.
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Against this backdrop, emerging market (EM) central banks are forced to choose between monetary policy independence and currency stability. The combination of dollar strength and weakness in yuan is putting depreciation pressure on EM currencies. Many EM central banks are choosing currency stability, resorting to FX intervention to limit depreciation pressure on their currencies. Some such as Indonesia surprised the market by hiking interest rates to limit depreciation pressures on its currency.
Against this uncertain global backdrop, the Reserve Bank of India (RBI) is treading the fine line between monetary policy independence and currency stability. The rupee has shown remarkable stability against the dollar, with RBI’s FX intervention limiting two-way volatility. FX reserves remain ample providing a shield against changing global dynamics. A measure for FX reserve adequacy is import cover which is currently tracking at 11.5 months (spot reserves plus forward book). This measure implies that current level of FX reserves can purchase (or cover) 11.5 months of imports. This is more than adequate and significantly higher than the taper tantrum period of 2013, when the rupee saw sharp depreciation pressures. Import cover during 2013 was as low as 6.6 months.
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Domestic growth conditions in India remain strong, supported by capital expenditure (capex) cycle and urban consumption. FY24 GDP growth print was stronger than expected at 8.2%, significantly higher than the government’s Advanced Estimate of 7.6%. The recovery has been led by capex cycle supported by government expenditure. Consumption growth has been more subdued with strong urban consumption countered by rural demand weakness.
Significant progress has been achieved on the disinflation front with India’s Consumer Price Index-based inflation (CPI) moderating to 5.4% in FY24 from 6.7% in FY23. The outlook for inflation remains favourable with inflation expected to moderate to 4.5% in FY25, assuming normal monsoon. However, in the June meeting RBI will maintain a cautious tone as food inflation remains closer to 8% in April 2024. The prevailing heat wave conditions have kept food inflation risks alive, which will need to be monitored.
Strong growth conditions will not hinder moderation in headline inflation as the economy is showing no signs of overheating. This is reflected by core inflation remaining at historical low and low current account deficit. Hence, once food inflation eases, conditions are favourable for headline inflation to move towards the 4%-target in FY25.
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In the June policy, RBI is expected to maintain status quo on policy rates, as headline inflation remains above target levels. Policy focus remains on ensuring inflation aligns with the 4%-target on a durable basis. The policy stance is likely to be retained as ‘withdrawal of accommodation’, signaling that the RBI is not in a hurry to cut interest rates. Strong growth conditions provide RBI policy space to remain on pause till further clarity is available on inflation and Fed policy outlook.
The author is chief economist at IDFC FIRST Bank. Views expressed are personal.