MPC should wait and watch as global risks complicate rate decisions

Global uncertainty demands caution on monetary policy

The six-member Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is meeting this week for the final time this financial year. This is also its first meeting since Sanjay Malhotra assumed office as governor. Market participants will closely watch the outcome of the meeting on Friday, as it comes soon after the Union Budget. Several analysts believe this is the right time to begin the easing cycle, primarily for two reasons. First, growth in the Indian economy has slowed considerably. The First Advance Estimates of the statistics department for the current year shows the economy will grow by 6.4 per cent compared to 8.2 per cent in 2023-24. Second, given the government has done well on the fiscal front in terms of containing expenditure, it’s time for the RBI to support growth with lower interest rates.

 

While there is merit in such arguments, it is worth remembering that growth is not the only objective of the RBI. The monetary policy’s primary objective according to the law is “... to maintain price stability while keeping in mind the objective of growth”. Thus, ensuring that the consumer price index-based inflation rate is durably aligned with the 4 per cent target is important. The inflation rate for December came at 5.2 per cent. While overall food prices have moderated, they remain elevated. An analysis by economists at Axis Bank showed that the proportion of food items with an inflation rate over 6 per cent increased to 33 per cent for the first time since October 2020. With the expected increase in capital expenditure in the last quarter, there could also be pressure on the core inflation rate. The December projection of the MPC showed the inflation rate will moderate to 4 per cent by the second quarter of 2025-26, which can increase space for policy accommodation.

 

However, the global environment has changed significantly since the last MPC meeting with increased risks to inflation outcomes. Trade tensions have increased markedly even as American President Donald Trump has delayed his decision to impose tariffs on imports from Canada and Mexico. Meanwhile, China has retaliated against the imposition of a 10 per cent tariff. Mr Trump has indicated that the United States will impose tariff restrictions on imports from the European Union too. Trade tensions and higher tariffs could potentially disrupt supply chains, resulting in higher import prices for India. Besides, higher tariffs would push up the inflation rate in the US. According to one estimate, the imposition of a 25 per cent tariff on Canada and Mexico can push up the inflation rate in the US by over 1 percentage point. Tariffs on other countries and regions will only add to the problem and reverse the disinflation process. This would seriously complicate policy management for the US Federal Reserve.

 

The possibility of higher inflation and higher interest rates for a longer period will further strengthen the dollar, resulting in increased volatility in foreign-exchange markets. There would be pressure on the rupee, which is significantly overvalued. The RBI is allowing the rupee to depreciate — as should be the case — and will have to do so for some time in the given circumstances. However, rupee depreciation will affect import prices and influence inflation outcomes. Thus, given the uncertainty on the external front with implications for inflation outcomes, it will be prudent for the MPC to wait and watch at this stage. Meanwhile, the RBI should actively address the liquidity issue, which can create unnecessary friction in the system.