India’s monetary policy panel should hold policy rates steady for the time being

A wait-and-watch approach would be best. (REUTERS)
A wait-and-watch approach would be best. (REUTERS)

Summary

  • The Reserve Bank of India’s rate-setting committee should retain its focus on price stability. This will help steady the rupee and aid economic growth. While RBI waits for external uncertainty to lift, it could use other tools to manage liquidity.

In its February meeting, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will deliberate on whether the trajectory of policy rates has reached an inflexion point from where an easing cycle can begin. 

With a new RBI governor at the helm, the MPC will consider the latest information on consumer price index (CPI)-based inflation and GDP growth available since the last meeting. 

Average headline CPI inflation in the third quarter of 2024-25 at 5.6% was well above the target, though in line with RBI’s baseline estimate. The National Statistical Office’s first estimate placed real GDP growth at 6.4% in 2024-25, again largely in line with RBI’s forecast of 6.6%. 

Given these in-line outcomes, the MPC will decide the way forward based on its outlook on growth and inflation risks.

Also Read: RBI must weigh its monetary policy options carefully under conditions of high uncertainty

Near-term risks to price stability have risen since the December meeting.

The rupee has depreciated by over 3%, weighed by renewed dollar strength and increased financial-market volatility amid heightened uncertainty around US tariff plans and their impact on inflation and rates. 

The US Federal Reserve has issued a hawkish forward guidance and signalled fewer rate cuts in 2025, triggering a risk-off mood among investors. 

According to the baseline forecast of RBI, headline inflation is expected to hold above its 4% target for the next 6 months. High but easing food inflation and sticky core prices are likely to keep it in the 4.5-5% range during that period. 

A weaker rupee presents an upside risk to that trajectory. Pressure on the rupee can intensify as the dollar’s strength and Chinese yuan’s weakness are likely to persist. 

Also Read: Ajit Ranade: Rupee depreciation is inevitable but exchange-rate volatility is not

Higher relative inflation in India is also contributing to rupee overvaluation in trade-weighted inflation-adjusted real effective exchange rate (REER) terms. 

That will get corrected through nominal depreciation and require vigilance on price stability. The pace of disinflation as envisaged in the baseline forecast is thus at risk from imported inflationary pressures.

The outlook on growth, on the other hand, is reasonably strong, with GDP expansion likely to pick up in the second half from the first, helped by an uptick in private consumption. 

While real GDP growth for 2024-25 is estimated to be lower than last fiscal year’s 8.2%, nominal GDP growth at 9.7% is expected to be unchanged from 9.6% last year. This is suggestive of higher inflation having pulled down real growth, particularly hurting mass urban demand and highlighting the need for a cautious monetary stance. 

The International Monetary Fund projects growth in India to hold around 6.5% in the next two years, in line with the economy’s potential. 

This appears plausible. 

Continued support for fixed investments in the Union budget for 2025-26 will help underpin growth. The Centre’s focus on capital expenditure along with fiscal consolidation is likely to continue, aided by stable tax revenue growth. 

In 2024-25, a contraction in capital spending by the Centre has slowed the growth in capital formation; its contribution to headline growth has almost halved compared to the year before. 

That is likely to reverse with a pick-up in public capex, which would help drive aggregate demand as well as potential growth higher.

Private consumption, the largest component of GDP, will also be aided by an ongoing recovery in rural demand on the back of improved farm-sector activity, while urban demand will get support from relatively stable growth in services.

Also Read: Vivek Kaul: The Union budget should focus on reviving private consumption

Thus, the growth outlook is of a return to its potential level after three consecutive years of over 7% growth. Considering increased risks to inflation, a status quo on policy rates may be prudent, especially to support growth. 

A wait-and-watch approach will also help provide more clarity on spillovers from external developments.

In the meantime, RBI can manage liquidity conditions in the banking system to ensure that the operating target—the weighted average call rate—remains within its policy-rate corridor. 

Since mid-December, liquidity has returned to a deficit, amid a build-up in government cash balances and RBI dollar sales to contain exchange-rate volatility. 

RBI had cut the cash reserve ratio (CRR) by 50 basis points in December and continues to address liquidity tightness through measures like daily variable rate repo (VRR) auctions. 

As a result, the call rate has hovered between the repo rate of 6.50% and the marginal standing facility (MSF) rate of 6.75%, suggesting that despite liquidity tightness, short-term rates have remained largely stable. 

Bank deposit and lending rates too remain stable. 

Bank credit growth has slowed down this year, in part due to regulatory measures. But at 12.5%, it is holding well above nominal GDP growth. 

Yield movements in the bond market (both government and corporate) also remain orderly, suggesting that financial conditions are broadly supportive. 

Other than frictional pressures on liquidity, RBI will also be closely monitoring the decline in the durable liquidity surplus, which now stands at 64,350 crore, down from its peak of 4.885 trillion in early October. 

A durable liquidity shortage can push rates higher than warranted. Moreover, any easing in monetary policy rates without adequate liquidity in the system will dilute their effect. 

With a CRR cut already undertaken, RBI has the option of making open market purchases of government bonds, especially if its dollar sales drain durable liquidity.

Overall, price stability should remain the focus of monetary policy. 

This will help support growth while maintaining macroeconomic stability amid heightened financial and capital-flow volatility. 

A wait-and-watch approach would be best. 

Moreover, given the uncertainty around US industrial, fiscal and monetary policies, supporting the rupee through price stability will help manage any adverse spillovers. A rate cut at this stage without surplus liquidity may not help bring down rates in the wider economy. 

And, given that the room for monetary easing is limited under a ‘neutral’ policy stance, it will reduce the space available to support growth in the future if the need arises.

These are the author’s personal views.

The author is chief economist, IndusInd Bank Ltd.

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
more

topics

MINT SPECIALS