RBI's cautious stance could cost growth, bold rate cuts need of the hour

Given the long lags in monetary policy's impact on the real economy, too much caution could prove unnecessarily costly

With consumer price index (CPI)-based inflation dropping to 3.16 per cent in April and likely to fall below 3 per cent in May, is the Reserve Bank of India (RBI) — through its Monetary Policy Committee (MPC) — falling behind the curve again? The RBI has historically been a poor predictor of inflation. It was slow to reduce the repo rate from 6.5 per cent throughout 2024 and has only now started to ease it slowly, with 25 basis point cuts in both February and April. Meanwhile, the real repo rate now stands at an exceedingly high +2.84 percentage points.

 

This is the same mistake made between 2015 and 2019, when real rates were kept extremely high — averaging +2.2 percentage points — and hurt economic growth (see table). At that time, the RBI’s inflation expectations were seriously flawed and consistently higher than actual inflation. This persistent error kept real repo rates too high for a prolonged period. The RBI (and the MPC) became what economic literature refers to as “inflation nutters” — that is, they focused solely on inflation and not on their dual mandate of growth and inflation.

 

Subsequently, under a new team, the RBI deftly helped India navigate the Covid crisis. As I argued in this paper in March 2024, the mandarins on Mint Street not only kept monetary policy loose (but not too loose) from 2020 to 2022 to address the pandemic-induced crisis, but also began tightening by August 2022 to rein in inflation, which had reached 6.7 per cent that year. This was more than 2 percentage points above the 4 per cent inflation target, breaching the upper limit of the tolerance band under India’s flexible inflation targeting (FIT) regime. (see table)

 

To its credit, the RBI avoided the mistakes made in the period after the global financial crisis of 2008/9, when it kept repo rates too low for too long. Combined  with a very loose fiscal policy, this set off a period of high inflation, averaging above 10 per cent from 2009-2013. This prolonged period of high inflation contributed significantly to the United Progressive Alliance’s election loss in 2014.

 

By 2014, the RBI was forced to raise the repo rate to 8 per cent to bring inflation down. Inflation eventually fell to 4.9 per cent by 2015, aided by tighter monetary policy and a sharp decline in oil prices. Crude oil prices dropped from $108.56 per barrel in 2013 to $98.47 in 2014, then fell sharply to $52.32 in 2015 and further to $43.67 by 2016.

 

Many experts attribute the subsequent period of low inflation to the introduction of the FIT regime, but that is not true. By the time India adopted FIT in 2015, inflation had already fallen. It remained low all the way to 2019 due to excessively tight monetary policy and low oil prices. My own analysis shows that once you factor in the effects of monetary policy and imported inflation, targeting per se had no additional contribution to lowering inflation. Economists Surjit Bhalla, Karan Bhasin, and Prakash Loungani² show more widely across countries that the benefits of targeting inflation are hugely exaggerated.

 

Given the long lags before monetary policy’s impact on growth and inflation becomes visible, the main problem now, in my view, lies in inflation forecasting, where the RBI needs considerable improvement. The RBI is currently predicting inflation at 4 per cent for FY26, but inflation may turn out to be much lower, especially with the prospect of lower global oil prices and stronger agricultural growth in India. Earlier in the year, there was a risk that rupee depreciation would contribute to inflation, but with a weakening US dollar that risk has diminished.

 

The RBI needs to act more swiftly and boldly to lower the repo rate to avoid the mistakes made during the period 2015–2019. The current set of technocrats leading the RBI are not “inflation nutters”— at least I do not think they are —and pride themselves on following the data. But they are behind the curve in lowering rates. Even with the RBI’s inflation expectations for the year at 4 per cent, which I have already explained is too high, the repo rate could be reduced rapidly to 5 per cent, 100 basis points lower than where it is today. With the European Central Bank cutting rates rapidly and the United States  Federal Reserve likely to do so later in the year, the RBI can cut rates move aggressively to help bolster India’s  growth and reinvigorate domestic demand, especially in the face of a much tougher external environment, where global growth is likely to decline due to tariff wars and a huge spike in global uncertainty.

 

Even with Q4 FY25 gross domestic product growth jumping to 7.4 per cent, the RBI must not feel complacent on the growth front. The monetary stance in the last meeting had already shifted to accommodative towards growth. Many experts and even some MPC members will argue for a calibrated and cautious approach and vote for a 25 bps cut in the repo rate. But given the long lags in the effects of monetary policy on the real economy, too much caution could prove unnecessarily costly. Bolder action is needed from the current set of mandarins on Mint Street. The data indicates that a larger cut of 50 basis points in the repo rate in June would be warranted, especially now, when India needs to rely even more on domestic demand to keep the growth momentum. 

The author is distinguished fellow, Isaac Center of Public Policy, Ashoka University, and co-author Unshackling India, Harper-Collins 2021, Financial Times Best New Book in Economics, 2022.

 

1. https://shorturl.at/pM8qu

 

2. An assessment of the performance of inflation targeting | CEPR