The Reserve Bank of India should defy the curve and cut rates
- India's central bank needs to show foresight again and cut rates ahead of the US Federal Reserve to make money cheaper and revive private capital expenditure, which is necessary to sustain the post-pandemic growth revival amid fiscal constraints that could stay the government’s hand.
The worldwide synchronous rise in inflation in 2022 was a rare phenomenon. Many of us who joined the workforce in the last 20 years had never encountered anything like this. The 7.3% inflation in advanced economies was nothing short of a spectacle even for the generation Xers. Central bankers around the world put up a great fight to attain what theoretically was unattainable—balancing inflationary risks without disrupting the post-pandemic economic recovery.
After two years of intense battle with inflation, the verdict is becoming clearer on how these policies fared. The US policy machinery stands tall in its ability to bring inflation down to less than 3% from a high of 8% in 2022. At the same time, US real gross domestic product (GDP) growth stayed above 2%. Though this growth has come at the cost of extremely high public debt and could pinch in the future, for now the US economy appears to be in good shape.
At a time when sharp price rises were forcing major economies to adopt tighter monetary policies in early 2022, the Reserve Bank of India (RBI) was a late joiner. It announced its first repo rate hike of 40bps in May 2022 through an ad-hoc announcement. The unscheduled hike took markets by surprise. Equity markets declined by 2.3% while the 10-year benchmark G-Sec yield climbed 30bps overnight. A recent RBI working paper 'Equity Markets and Monetary Policy Surprises' indicates that the shock from unscheduled policy announcements is usually high on market variables.
Thereafter, there was a linear rise in rates till February 2023. In April 2023, RBI again surprised the markets by announcing a pause, but this time in a scheduled meeting. This was a positive surprise, as the market was largely expecting more hikes, especially since the US Federal Reserve was not done hiking its target rate by then.
It was widely believed that any deviation from what the Fed was doing could send the Indian currency on a downward spiral against the dollar. That never happened. Instead, the dollar-rupee turned out to be the least volatile currency pair even when compared to perceivably stronger pairs like the dollar-euro, dollar-pound or dollar-yen. RBI policymakers demonstrated their ability to move ahead of the curve with a high degree of confidence to protect the economy.
All was good till this point. The pause led markets to price in a rate cut within the next three meetings. However, higher vegetable prices in domestic markets, the Gaza conflict and sticky inflation in the US forced RBI to raise its guard again against any runaway inflation that could jeopardise its achievements of the past year.
There is no doubt that RBI has emerged as a robust central bank, with a fantastic report card on lowering inflation without creating undue hindrances for India’s consumption and economic growth revival. It also managed to ensure a stable currency, attracting foreign funds at a time when yield spreads with developed markets were declining.
RBI now needs to once again act ahead of the curve by adopting an accommodative stance. It needs to acknowledge the prevailing geopolitical risks as transitory. Globally, analysts are convinced of a base case scenario wherein Iran and Israel will not get engaged in direct combat. Also, the threat to inflation emanating from high oil prices will only materialise if Brent crude prices breach $100 a barrel i.e. an almost 40% rise from a year back. The probability of such a steep rise is low, with every large economy reeling under heavy debt and facing a likely slowdown or recession.
Another concern RBI has had is regarding volatile food prices, especially of fruits and vegetables. But it is highly unlikely that rate hikes can impact food prices. Unlike a television set or car, food is a necessity and not a discretionary product; its consumption cannot be regulated by making money expensive.
As global warming intensifies, food price shocks will become a widely recurring phenomenon. Monetary policy makers will need to internalise these shocks within their risk management models in a better way and not react retrospectively. After all, there is nothing a 6.5% repo rate can do if poor logistical infrastructure cannot preserve vegetables from a sudden heat wave.
Also read: Inflation is steady but price pressures may pose challenge for new government
India’s spectacular economic growth in the second half of 2023 was driven by public capital expenditure and high tax collections. Its future course will depend on a revival in private capital expenditure. This in turn is dependent on the cost of capital, which will come down only when RBI shifts its policy stance.
Considering this, RBI should cut its policy rate during their 24 June meeting. Defying the US Fed’s stance may appear to be a bold move, but it is a risk worth the reward. Unless liquidity conditions are eased systematically (instead of the ad-hoc interventions currently), any meaningful revival in private corporate investments will remain absent.
Lenders, especially non-banking financial companies (NBFCs), which serve as a major source of credit for micro, small and medium enterprises (MSMEs) and other segments like small developers and economically weaker consumers, will face severe impediments in extending credit to the last mile of the economy. This may not bode well for economic growth at a time when public investments are expected to slow to adhere to the Centre’s fiscal consolidation roadmap.
The author is chief economist of Piramal Group.
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First Published:17 May 2024, 03:30 PM IST
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