The wisdom of waiting: Why RBI held back despite inflation plunging

With inflation easing to 2.6%, RBI opts for caution, saving rate cuts for later

The October monetary policy — despite its remarkable inflation revision — was less a story of action than of careful inaction.

 

Inflation surprises in India often come dressed in the garb of oil shocks, monsoons, or sudden fiscal spurts. But this year’s shock has been of a very different kind – inflation has quietly tiptoed off the stage. And almost nobody saw it coming. At the start of the financial year, the RBI had placed its inflation forecast at 4 per cent — in line with its median target. But since then, a series of downward iterations have now brought it down to 2.6 per cent — marking a stunning 140 basis point revision in the last six months. 

 

Not just the RBI, even the most cautious economists have found themselves caught off-guard by the inflation decline this year.

 

This isn’t just a statistical quirk. The softness in food inflation, often the Achilles’ heel of Indian inflation, has turned out to be more enduring supported by healthy agricultural output. Meanwhile, demand is yet to fully roar back, keeping producers’ pricing power in check. To top it up, the recent GST cuts even with a partial pass-through are likely to lead to a substantial one-time price dip.

 

Meanwhile, global commodity prices have remained subdued, in no small part driven by China’s slowdown spilling into downstream Asia, adding to the cooling inflation trend. In turn, wholesale inflation has averaged at just 0.1 per cent so far this year while retail inflation has averaged at 2.4 per cent. The durability of this moderating trend is most visible when one strips down retail inflation of components like food, fuel, and other commodities like gold and silver — called core inflation. Over the last 12 months, this part of inflation has averaged at just 3.4 per cent.

 

So, here’s the puzzle. Does lower inflation automatically mean that the central bank continues to press harder on the rate cut pedal? Perhaps not.

 

Central banks are rarely allowed the luxury of simply celebrating good numbers today with their horizons stretching at least six to twelve months ahead, sometimes longer. It’s true that the RBI’s governing mandate is to steer inflation close to 4 per cent, but its decision-making calculus is wider. It needs to study shifting future expectations, lagged effects of easing already done, and more esoteric considerations around where the “ideal” terminal policy rate should be versus the notional “neutral” policy rate.

 

Neutral policy rate is a concept denoting a point where monetary policy is neither slowing growth nor artificially juicing it. To simplify, in an easing cycle, the ideal terminal policy rate is usually lower than the neutral rate while in a tightening cycle it is kept higher. The real neutral policy rate is estimated to lie anywhere between 1.4 to 1.9 per cent. With inflation pegged at 4.5 per cent by middle of next year and with the policy rate currently sitting at 5.5 per cent, the real policy rate is already at 1 per cent — with monetary policy being significantly accommodative in practice right now.

 

The question of further rate cuts, therefore, now rests less on this year’s inflation trends but more on what happens to growth and how much further support it requires.

 

The RBI revised up its growth forecast for this financial year to 6.8 per cent, powered in part by strong Q1 numbers. Yet it indicated caution by trimming growth expectations for the second half of the year, wary of lurking risks or unknows including tariffs and their second-round impacts, the strength of the punch for GST rate cuts and concerns around global growth.  It is a sober recognition that while numbers look good today, tomorrow’s risks remain unsettled.

 

This discretion matters in central banking as rate cut ammunition is not infinite. And therefore, the timing of rate cuts becomes important. Used at the right instance, they can not only lower borrowing costs and spur demand but bring in a broader positive “sentiment” effect in the economy — steading nerves when the economy most needs it. But utilised prematurely, they can limit the central banks’ firepower if headwinds rise significantly in the future.

 

With the impact of the GST rate cuts, good monsoons, and recovery in rural demand, past interest rate cuts and income tax cuts still playing out in the economy, an interest rate cut in the October policy could have turned out to be a wasted bullet. More so because there remains considerable uncertainty over tariff outcomes and its impact.

 

Going forward, if economic momentum disappoints, the RBI can very well utilise this newfound monetary space — created by low inflation —to reduce the repo rate both in the December and February policies, aligning it with a lower terminal rate. But for now, waiting was the best option.

 

The writer is principal economist, HDFC Bank