Clipped from: https://www.thehindubusinessline.com/opinion/reaching-real-equilibrium-policy-rates/article69541943.ece
To counter the global trade turbulence, central banks must use the monetary space available to them
MPC must give priority to the real sector and the real rates that affect consumption and investment decisions | Photo Credit: baona
Recent data confirms that India’s growth slowdown was cyclical and not structural. Driven by a revival in government spending, growth recovered marginally to 6.2 per cent Q3 FY25 from 5.6 per cent in Q2. This, together with the expected reversal of the Trump trade, led to a rise in the rupee and Indian stock markets.
The MPC was behind the curve in not cutting repo rates and contributed to the cyclical slowdown. An inflation targeting regime has to be inherently forward-looking, since monetary policy acts with lags. Last year itself it was clear that inflation was coming down to target. Headline inflation fell below target in February and the expected value for FY26 is at the target of 4 per cent.
The start of the rate cutting cycle in February was welcome. Cuts were gradual in view of global uncertainties. But now the reciprocal tariff event is behind us. India is hit, but less than its neighbours. Slowing global growth and trade, however, will create spillovers for India. Monetary policy has space to cut and must use it as a counter. The cut should have been 50bps in April in order to bring the real rate closer towards equilibrium levels, more so since the real repo has been too high for several months now. Pass through has started in market rates and could be faster with a larger cut.
Arguments for going slow
Resistance comes from those who want small steps in uncertain times — this is the typical view that EMs can only be at the receiving end of global shocks. But the ability of some countries to counter shocks must be recognised and used.
Fear of future heat waves, climate change and food price shocks is another perennial bugbear. Such fears have in the past kept the RBI from cutting when there was space. As a result, real rates rose too high and growth fell. Waiting for more clarity can lead to missing the bus. Although Punjab farmers grab headlines, many States have liberalised agricultural marketing, private start-ups are improving vegetable supply chains. Food items are becoming more diversified and a smaller part of the consumption basket.
A major source of resistance to sharper cuts is from banks that fear a contraction in margins because slow deposit growth lowers their ability to reduce rates. They want durable liquidity to be in surplus first and argue for a gradual non-disruptive pass through.
The voice of financial markets tends to dominate monetary policy discussions. But they are interested in the nominal policy rate and how it will change. It is the MPC that must give priority to the real sector and the real rates that affect consumption and investment decisions. Despite their fears, bank profits have remained strong as rates softened. Costs of market borrowing fall and they benefit from treasury mark-ups. Ultimately banks do well as the economy does well. And they have sufficiently diverse income sources to benefit both from rising and falling interest rate cycles.
Credit growth is the fastest for MSMEs; NPAs would be lower on affordable loans. Margins are among the highest in the world and have to come down with fall in costs.
The large liquidity injections of the past few months should also move banks from a liquidity first view to a ‘liquidity also and liquidity fast’ view. It is clear the RBI does have the tools and now the willingness (signalled in the change in stance to accommodative, which restricts them to either pause or cut rates) to inject whatever liquidity is required, regardless of foreign capital movements.
The plan seems to be to keep durable liquidity in surplus, which is required in Indian conditions of large exogenous liquidity shocks and limited inter-bank lending.
But there must not be over-reaction in either rate cuts or liquidity injections. Over-stimulus results in over-tightening and increases volatility. The aim must be to smooth shocks. Timely action mitigates the need for excess action. Talk of a negative terminal rate is misplaced. In Indian conditions a low positive real repo rate sustains demand, while balancing the requirements of savers and investors.
Rupee reversals
Global shocks continue but the belief in US exceptionalism that led to large outflows from EMs after the US election has reversed. The fall in DXY has reduced pressures on EM currencies. Oil prices are also soft. Despite tariffs possibly stoking inflation, the Fed may cut more if US growth falls.
Net FPI outflows during January and February 2025 became inflows from March. Debt inflows were also positive in March even though interest differentials with the US narrowed. These reversals should reassure analysts who worried about using up reserves and debt outflows due to lower interest rates. Concern rises to a crescendo when there are outflows and the rupee is depreciating. But these global shock led episodes are always temporary given the diverse players in Indian markets and our growth prospects. The view that the rupee was depreciating sharply because it had been held too steady turned out to be incorrect as the rupee appreciated back above 85, even as reserves were rebuilt. The usefulness of the RBI stance of intervening only to prevent excess volatility and strategically using reserve buffers was proved once more.
Again the market wants volatility, which helps them make money, but excess volatility hurts exporters — the real sector. Some volatility is required for market price discovery and for creating incentives to hedge FX risk, but too much raises interest rate spreads and costs.
Therefore, again the RBI has to rise above markets and keep an eye on real misalignment. Even in the 2023 period of low nominal volatility a crawling depreciation ensured there was no real appreciation. A real effective exchange rate index of around 100 has supported trade in the past and sustained deviation from it is not desirable. Since the Renminbi has a large weight in the trade weighted index, there is adjustment for its depreciation if persistent real misalignment is prevented.
Analysis based on standard textbooks often gets it wrong for the Indian economy. In addition to theory, an economy’s structure and current circumstances need to be kept in mind. For example, the close link between domestic and US interest rates holds only in countries where debt flows are unrestricted.
A face-off between the CB and the government is required when the latter relies on deficit financing but not if it is reducing deficits and spending in ways that lower inflation. Under such conditions, monetary policy must use the space it has to cut and quickly reach the required real policy rate thus reducing the volatility of Indian growth.
The writer is Emeritus Professor, IGIDR
Published on May 5, 2025
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