Monetary policy: Emotive choices and immediate response mechanism

The RBI kickstarted its post-covid normalization of monetary policy in April 2022. Since then, India’s monetary policy trajectory had been moving forward without any humps amid well-aligned expectation of financial market participants, corporates, and the government. With India’s GDP growth averaging at a healthy 7.6% during FY23 and FY24, the strict pursuit of inflation management by the central bank faced no friction from key stakeholders in the economy.

However, in recent months alternate forms of inflation management are now being publicly debated. Willy nilly, the conclusion in such debates appears to be veering towards the notion that India’s Monetary Policy Committee is maintaining its policy rate higher than necessary to tame CPI inflation, which: (i) suffers from outdated statistical representation of food basket, (ii) does not reflect broad-based price pressures as select food items are playing havoc, and (iii) over the last few quarters has been moving in divergence with the underlying subdued core inflation trend, that is generally considered to be a better proxy for demand side pressures.

Recently, the finance minister and the commerce minister made public their preference for a lower monetary policy rate. While not as intense, this is reminiscent of the earlier difference in opinion between the central bank and the government on the issue of monetary policy—something unseen in the current governor’s regime since December 2018.

The perceptible weakness in the recently released GDP data is now bound to intensify the debate on monetary policy. To our minds, the GDP growth print of 5.4% in Q2 FY25 posed the largest ever ‘peace time’ negative surprise compared to an expectation of 7.0% growth provided by market participants as well as the RBI at the start of the quarter.  

So, what should the RBI and its MPC do in the upcoming policy review scheduled for 6 December? Should the central bank stick to its last-mile inflation management narrative, or is it now time to signal a switch from the current ‘neutral’ policy stance to some form of ‘accommodation’?

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Given the immediate backdrop, this may sound emotively perplexing with the RBI not having an easy choice at its disposal. In such times, it is necessary to stick to the first principles while acknowledging and making nuanced allowances for policy frictions.

Avoid temptations

There is now a strong likelihood of around 50 basis points (bps) downgrade to consensus FY25 GDP growth estimate of ~6.9%. Past monetary reaction function indicates a median threshold of 5.4-6.1% on GDP growth for the RBI to turn accommodative. This implies that the MPC still has room to tolerate GDP growth moderation pressures while ensuring inflation remains well anchored. Besides, a 6.0-6.5% growth outturn is still healthy in the current global environment, besieged by heightened geopolitical tensions.

As a broader point, it is important for the government to continue focusing on quality expenditure to support growth. Last but not the least, the government ought to fast-track the statistical refinement of GDP computation with focus on a revamped industrial basket along with the construction/application of a proper deflator (WPI is inadequate and obsolete and needs to be replaced by a PPI).

Emphasize policy coordination for inflation management

Some parts of recent inflation discomfort have fiscal origins. Duties on edible oils have raised inflationary pressures, while scope for reducing retail fuel prices has not been utilized despite moderation in global crude oil prices. The government could explore corrective intervention to balance revenue requirement (which in our view is currently not facing any challenges) with inflation management.

Keep the powder dry

Global economic environment is expected to face known-unknown risks under the new Trump administration. It is important to preserve monetary policy ammunition (CPI inflation is still untamed and is hovering close to the upper tolerance threshold of 6.0%) and be reactive rather than proactive to the evolving situation while preserving overall macro-financial stability. The timing and magnitude of monetary policy easing can potentially have a detrimental impact on the rupee, which is currently at an all-time low on account of bullish dollar sentiment.

Activate immediate response mechanism

Although the MPC can continue to play the patience game, the RBI needs to fine-tune the operating framework of monetary policy, which is currently facing pressure from unsterilized FX intervention. As per our estimates, the RBI since October 2024 has sold about $30 billion from FX Reserves in a bid to smoothen rupee volatility. This has eroded the core liquidity surplus (which is down to just 0.6% of NDTL currently from 2.2% in September-end 2024 and is now putting pressure on short-term money market rates. If unaddressed, this could start feeding into lending/borrowing rates in the economy, thereby compromising the neutral policy stance.

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We expect the RBI to address this by announcing a 50 bps CRR cut, thereby infusing ₹1.1 trillion of durable liquidity. Notably, the current CRR of 4.5% is higher than its pre Covid average of 4.0% and needs to be normalized, in line with other policy tools.

Macrofinancial stability has been a hard-earned economic badge of honor for India. It is imperative that policymakers preserve this in a chaotic global environment, refrain from near-term temptations, while being agile enough to fine-tune targeted response mechanisms.

Vivek Kumar is economist, QuantEco Research