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

Summary
- Trump’s policies have added to our contextual complexity. Faced with conflicting demands, India’s central bank should wait for key uncertainties to play out before making a policy rate move.
The end of the killing and destruction in Gaza, the Hezbollah-Israel peace deal in Lebanon and the regime change in Syria have considerably eased tensions in West Asia.
But high global uncertainty prevails.
How long will the Gaza accord last? War is still ongoing in Ukraine, as are civil wars in Sudan and Congo.
Most disruptive of all, US President Donald Trump’s inaugural address made clear that he will do much of what he had threatened—massive deportation of illegal and legal migrants; drastic tariff hikes against adversaries, neighbours and allies; a trade and technology war against China; an exit from the Paris Accord; and the maximization of US oil production.
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Cutting the supply of low-cost migrant workers and hiking import duties will sharply increase US production costs and rekindle inflation.
The Federal Reserve will then have to halt—perhaps even reverse—its gradual reduction of interest rates. Recent US growth has been robust, but raising interest rates again will weaken it.
A full-fledged trade and technology war with China will further disrupt global supply chains and technology flows. Although this will also yield some opportunities for other countries, it will add to China’s woes in the real-estate sector.
Despite China’s stimulus package, the International Monetary Fund projects that the growth of its economy will fall from 4.8% in 2024 to 4.6% this year and further to 4.5% in 2026.
Such a slowdown in the world’s largest and second-largest economies will hurt global growth, calling for expansionary macroeconomic policies and lower interest rates around the world.
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However, markets have already factored in a possible reversal in US interest-rate policy. For the past couple of months, there has been a sustained outflow of capital, especially from emerging markets like India, to the US.
This has depleted the foreign-exchange reserves of these countries and weakened their currencies, thereby calling for an increase in interest rates in these economies.
India’s recent growth-inflation dynamics and monetary policy options have to be viewed in this complex global backdrop. Much has been made of the first advanced estimate (FAE) of national income, estimating 2024-25 growth at 6.4%, instead of the earlier projected 6.5%. However, the FAE is largely based on data for the first half of the financial year.
Public expenditure, especially capital expenditure, was considerably subdued in the first half due to the election code of conduct and a pause in spending as the government reset itself for a third term. There was also adverse weather.
Most high-frequency indicators suggest stronger growth in the second half. For the whole year, it could be in the 6.5-7% range. Given the gloomy global conditions, this rate sustained year after year is an impressive achievement. India remains the fastest-growing major economy in the world.
Growth in China, the second-fastest growing major economy, at 4.8%, is well behind India’s 6.4% clip.
India’s sustained high growth has been made possible mainly by high public investment.
A revival of the private-investment cycle is unlikely amid the present uncertainty, including over the stability and continuity of government policy.
Finance minister Nirmala Sitharaman has established an enviable track record of maintaining very high rates of annual capex growth of 25-40% while also achieving her targeted fiscal deficit reduction every year.
This has been made possible by the buoyancy of most taxes—except excise duties and corporation tax—combined with a sharp compression of revenue expenditure. The latter has been budgeted to grow by only 4.1% in 2024-25.
This year, Sitharaman is again likely to meet the budgeted deficit target, if not improve upon it. However, there may be some shortfall in the capex target.
While impressive by global benchmarks, India’s growth has been far short of what is required to pick up the slack in employment or the 8% growth needed to accomplish the Viksit Bharat goal of making India a developed country by 2047.
Meanwhile, inflation has been moderate.
It has remained above the 4% target mainly due to high food prices, but within the central bank’s tolerance zone of a 2-percentage-point variance on either side.
Also, on the fiscal side, there is not much headroom for more expansionary policies, given the high central government debt of about 87% of GDP, which needs to go down.
This, along with the negative impulses from the global economy, point to the need for an accommodative monetary policy stance and a reduction in the policy rate.
On the other hand, persistent outflows of foreign portfolio investment require an increase in the policy rate. There are also concerns that high food prices may spill over to headline inflation, which also calls for a higher policy rate.
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Given these competing pressures in a complex situation, the Reserve Bank of India is best advised to maintain its current policy rate and neutral stance. It should allow a few months for some of the prevailing uncertainties to play themselves out, and to assess the impact of the forthcoming Union budget, before it makes a new policy rate move.
Meanwhile, it can continue to address the liquidity deficit through its variable repo rate (VRR) auctions and a further reduction in the cash reserve ratio (CRR) if required.
These are the author’s personal views.
The author is chairman, Centre for Development Studies.