A macro tightrope walk: Balancing domestic slowdown, global challenges

The challenge for macro policy is to respond to the domestic slowdown without appearing to let its guard down against a hostile global environment

Macroeconomic policymaking in India has its work cut out in 2025.

 

First, American exceptionalism has induced a significant tightening of global financial conditions. Not only has resilient growth in the United States (US) outperformed other developed economies but has made the last mile of disinflation challenging. Market expectations of easing by the US Federal Reserve have waned from five cuts to just one in 2025. Consequently, US 10-year bond yields have tightened 100 basis points since September and the dollar index is approaching 20-year highs. This has put enormous pressure on emerging-market currencies and the rupee has been no exception. 

Second, Trump 2.0 risks making the global backdrop more hostile. US tariffs will ratchet up global uncertainties and depress global capex and growth — as it did in the first trade war. Tariffs should also trigger more dollar strength. Meanwhile, punitive action against China will likely induce it to increasingly redirect its excess capacity to the rest of the world — including India — further threatening manufacturing prospects in those economies. The “known unknown” is whether Trump 2.0 accentuates US exceptionalism or undermines it. A trade war will slow global growth, but will the US be relatively insulated — at least initially — because of offsetting fiscal easing and deregulation at home? This will be the worst of all outcomes for emerging markets — weaker global growth but alongside a stronger dollar and sticky US yields. 

Meanwhile, India’s growth momentum has slowed in recent quarters. Urban consumption was the mainstay of private-sector demand but has waned as excess savings from the pandemic have been exhausted, formal-sector wages have slowed, and consumption-related lending has been tightened. Rural consumption is lifting but only gradually and there are limits, fiscal and absorptive, to the public-investment push the government embarked upon in the pandemic. Meanwhile, private investment awaits more demand visibility and will be disincentivised if more Chinese excess capacity finds its way into India. So the slowdown is more than just government spending getting off to a slow start this year. 

The challenge for policy is how to respond to the domestic slowdown without appearing to let its guard down against a hostile global environment. So what should the playbook be? 

First, monetary policy must not get trapped into an interest-rate defence of the currency if the rupee remains under pressure. The very purpose of adopting flexible inflation targeting and building a war chest of foreign currency reserves was to create two — relatively orthogonal — instruments for policy to deploy. Under this approach, policy rates and liquidity respond to domestic growth and inflation dynamics, while the rupee becomes the external shock absorber and sterilised forex (FX) intervention prevents disruptive rupee adjustments. 

This approach has served India well over the last decade. For starters, India’s large buffer stock of reserves bought the economy some monetary-policy independence, reflected in the policy-rate differential between India and the US narrowing sharply in recent years. Meanwhile, inflation expectations have remained anchored as inflation targeting has gained acceptance and credibility, and thereby given monetary policy more degrees of freedom. 

To now redirect monetary policy to defend the rupee — as markets will inevitably push for — will be counterproductive. First, it will cede monetary-policy independence at a time when (i) Indian and US business cycles could not be more asynchronous and (ii) domestic fiscal space is constrained. Second, if the rupee is kept artificially elevated, the resulting loss of competitiveness will contribute to an even broader tightening of monetary conditions. 

Instead, policy rates and liquidity must be calibrated to domestic inflation-growth dynamics. The exchange rate’s impact on monetary policy must matter to the extent that its movements contribute to inflation. There is finally some relief on food inflation. Food prices are rolling over and the Kharif and Rabi harvests should cement these dynamics. The consumer price inflation rate is therefore finally expected to head back to the 4 per cent handle in the coming months. Yes, a weaker rupee may be inflationary, but estimated magnitudes are not very large and, with demand slowing, some of the input-cost pressures are likely to be absorbed by firms. Meanwhile, the core inflation rate continues to remain in the 3-4 per cent handle, reinforcing the existence of meaningful slack in the economy. Given these dynamics and slowing growth, monetary policy must use the “flexibility” inherent in the framework to gradually ease policy rates to support growth. But easing will be efficacious only if the large liquidity deficit in the banking system — the result of large unsterilised FX intervention in recent months — is simultaneously replenished. 

Meanwhile, the rupee should be allowed to settle at levels warranted by its fundamentals with FX reserves used only to ensure any depreciation is orderly. Protecting any levels of the exchange rate in this global environment — with the dollar strengthening and the Chinese yuan likely to depreciate in the wake of US tariffs — seems both unsustainable and undesirable. Unsustainable, because even as India still has a war chest of FX reserves, they must be used judiciously, given this is likely to be a protracted battle. Undesirable, because the broad trade-weighted real effective exchange rate was at lifetime highs in November and an uncompetitive rupee will further weigh on growth. As the evidence has shown in India, a weaker rupee is economically stimulative. Furthermore, if India is subject to US tariffs, currency depreciation will likely be the inevitable market reaction to tariffs. 

On its part, fiscal policy is more constrained. With nominal gross domestic product (GDP) growing in single digits the last two years, public debt/GDP has begun to tick up again. To ensure debt ratios first stabilise and then come off — to make fiscal space for future shocks — more fiscal consolidation may be necessary in the coming years than currently envisaged. But it’s important to distinguish end-state deficit levels from the pace of consolidation. With growth momentum slowing, the pace of consolidation should be very gradual so that fiscal policy does not become pro-cyclical. 

Prima facie, cutting rates and slowing the pace of fiscal consolidation may seem to defy the conservatism that a hostile global environment warrants. But this is where buffers and frameworks matter. Both fiscal and monetary policies in India have been governed by credible frameworks that have anchored expectations and reduced risk premia in recent years. This, in turn, allows policymakers to pivot during periods of slowing growth. 

Of course, the real tonic that growth needs is persistent structural reforms to both accelerate its pace and make it more labour-intensive. The current moment presents a unique opportunity for India. Externally, another US-China trade war will accentuate the desire for firms to look for other locations. India must be ready, waiting and welcoming of these opportunities. Domestically, this is the first full-year Budget of the government’s third term and a unique opportunity to expend political capital and double down on reforms to simultaneously boost growth and employment and increase the economy’s external attractiveness. 

India’s economic history is littered with opportunities stemming from crises. In the slow-burning crisis that the global economy will likely create for itself through trade wars, deglobalisation and economic balkanisation, India must seek and find

its opportunity. 

The author is head of Asia Economic Research at JP Morgan. The views here are personal