India’s growth slowdown: Yes, RBI does need to respond

Economic growth in the second quarter was 3.2 percentage points below the rate of economic expansion in the December quarter in 2023-24. India had experienced seven quarters of declining growth just before the pandemic struck. It is still not clear whether the ongoing slowdown will be a similarly lengthy stumble or a momentary wobble because of transient influences.

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A lot of the discussion these past few days has been about how policymakers should respond to the growth shocker, but first it would be useful to examine the nature of the slowdown. Private sector demand has been weakening for some time.

Urban consumers have paused for a breath after a wave of hectic spending following the end of pandemic restrictions. Companies have still not been keen to build new capacity in their operations.

The government had stepped in to bolster domestic investment through spending on new roads, ports, airports and other types of infrastructure. However, government capital expenditure in the first half of the current financial year is lower than what it was in the same period last year, perhaps because of national elections in 2024. The net result is that fiscal support has further weakened.

The question that is buzzing in the air is whether the government needs to step in quickly to stimulate spending. The space for either higher government expenditure or meaningful tax cuts is limited.

The Indian government is still in the process of getting public finances back into shape after the pandemic shock, when it had to support economic activity even as tax collections collapsed. Public debt ballooned. This burden has to be gradually reduced through a combination of fiscal discipline and maintaining economic growth above the cost of government borrowing.

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The fiscal option is thus limited for now. That leaves the monetary policy lever. The Reserve Bank of India (RBI) faces a dilemma. Headline inflation is above its formal target, largely because of high food prices. Core inflation has been well under control, a sure sign that domestic demand is weakening.

There is a compelling case for the monetary policy committee (MPC), which is meeting this week to decide its next move, to look past temporary jumps in food prices, often the result of one-off factors such as unseasonal rains or heat waves, to reduce interest rates.

However, there is one catch. There is a possibility that high food prices will spill over into the rest of the economy, as workers demand higher wages to cover the higher cost of living or companies increase their prices to protect their profit margins. Is that happening in India right now? Neither the data from the labour market nor from corporate financial statements suggests that such an upward inflationary spiral is building up.

The central bank is more wary. In RBI’s latest monthly review of the Indian economy, it notes that the prices of processed foods have been moving up in response to a surge in edible-oil prices. And there are early signs that higher food prices have begun to push up the wages of household services such as domestic help or cooks. “The hardening of input costs across goods and services and their flow into selling prices needs to be watched carefully," says RBI.

There is a strong consensus in financial markets right now that the six members of the MPC will not immediately respond to the sharp decline in economic growth in the second quarter of the current financial year. In that case, RBI should take a first stab at the challenge by easing financial conditions, which have become tighter in recent weeks, in other ways.

The easing of Indian monetary policy can then be seen as a play in three acts.

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First, the MPC in its October meeting changed the policy stance from “withdrawal of accommodation" to “neutral."

Second, the central bank can ease financial conditions by releasing liquidity into the money market via more purchases of government bonds (open market operations).

Third, it could go for a rate cut in the first half of 2025.

Indian monetary policymakers are negotiating the twists and turns of economic life with faulty equipment to guide them. The inflation-targeting central bank depends on a consumer price index that is dated.

The index is usually updated every five years, as the relative importance of what people spend on changes with time, especially the fact that a family’s food bill tends to become less important as its income increases. The other issue is how free or subsidized food should feature in the Indian measure of retail inflation.

In a recent article in Business Standard, Barendra Kumar Bhoi, a former head of the monetary policy department at the Indian central bank, has estimated that retail inflation would be half a percentage point lower if it had been measured correctly, with an updated consumer price index. It is worth speculating if interest rate policy would have been different—in effect, less tight—if a renovated consumer price index had been released on time by the government.