Liquidity support is priority; rate cut a close call

RBI’s intervention in the forex market remains the elephant in the room influencing banking system liquidity. (PTI)
RBI’s intervention in the forex market remains the elephant in the room influencing banking system liquidity. (PTI)

Summary

  • The central bank’s recent announcement of durable liquidity measures (e.g., OMO calendar, 56-day repo and FX swap) will likely infuse around 1.5 trillion in the coming weeks, apart from the ongoing large VRR operations.

The backdrop of the monetary policy committee (MPC) meeting later this week is a complex one. Growth momentum has slowed in 2024-25. Headline retail inflation is still high despite softening from the recent peak. The government maintained strong fiscal discipline, despite offering tax concessions towards boosting private consumption, reflecting a decelerating expenditure budget. Importantly, this comes against a global environment of pressure on most emerging market (EM) currencies amid geopolitical volatility, US exceptionalism and a raging dollar. US Fed has paused after three consecutive rate cuts, while ECB and central banks in England and Canada continue cutting. Among EMs, Indonesia recently cut rates to aid growth, despite a weakening Rupiah.

Most inflation indicators markedly low

Back home, headline CPI averaged 5.6% during Q3 2024-25, but largely due to items beyond the influence of monetary policy (e.g., vegetables, precious metals). However, nearly all other important inflation indicators such as WPI, core-WPI, core-CPI and GDP deflators stayed discernably soft (averaged between 1% and 3.5%) during 2024-25. Thus, headline CPI inflation is elevated reflecting prices of only a handful of non-core items, while other inflation indicators are distinctly subdued.

The central bank predicts CPI inflation to average 4.4% during the next nine months up to September 2025. So, the MPC must decide whether to stay cautious given the high retail inflation prints in recent months or deliver a rate cut relying on the RBI’s forecast of benign future inflation—overall, it seems to be a close call in February, rather than being a done deal on either side. Also, the RBI has so far been categorical not to dilute focus on headline CPI. However, it will be interesting to figure out if there is a change in thinking around that in the coming days.

Liquidity support is priority

While a rate action seems to be a close call, liquidity support has clearly emerged as a priority for RBI, taking into account the contraction in system liquidity in recent weeks (daily average deficit of over 1.5 trillion since early-December). The central bank’s recent announcement of durable liquidity measures (e.g., OMO calendar, 56-day repo and FX swap) will likely infuse around 1.5 trillion in the coming weeks, apart from the ongoing large VRR operations.

Read more: How equity investors can ride the post-Budget wave

However, RBI’s intervention in the forex market remains the elephant in the room influencing banking system liquidity. India witnessed nearly $20 billion net FII outflows in the last four months, largely from the equity market, amid uncertain global macro-dynamics, repricing of fewer US policy rate cuts during 2025 and expectation of a tepid earning season back home.

Notwithstanding the pressure of FII flows, the expectation of a more supportive stance on liquidity stems from the fact that growth in reserve money—the measure of primary liquidity infusion by the central bank into the banking system—had fallen sharply to a compounded annual growth rate (CAGR) of merely around 7% since mid-2022, in sharp contrast to a long-term growth rate of 12-15%. A stronger growth in reserve money will likely boost durable liquidity for the banking system, and in turn support healthy credit growth for the productive sectors of the economy.

February meeting will act as a strong reference point for future

On the back of yet another disciplined Union budget and a sharp step up in liquidity measures from the RBI, expectations of a rate cut seem to have become stronger. However, arguments remain strong on either side as regards rate action in February. A persisting large liquidity deficit could limit the efficacy of a rate cut transmission and might tempt the RBI to spring further liquidity supportive measures while taking a wait and watch approach on the rate front amid the continued pressure on INR. Nevertheless, a hawkish pause on rates should be ruled out as it could further aggravate the ongoing growth softening trend.

Read more: India’s central bank needs reliable and frequent employment data as a policy input

On balance, it is fair to suggest that while a February rate action is still a close call, RBI will certainly continue to focus on liquidity support for the banking system leaving no tool off the table. The February meeting will be only the third meeting for the three external members of the six-member MPC, while for the governor it will be the first one. The MPC’s action and commentary in this meeting will serve as a key reference point and important guidance for monetary policy in the coming months.

Siddhartha Sanyal is author is chief economist & head of research in Bandhan Bank. The author thanks Sudarshan Bhattacharjee and Gaurav Mukherjee for assistance. Views are personal.

 

 

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