Task cut out for MPC after Budget's consumption boost as RBI decision nears

The budget has done its job. The big ask was for a consumption boost, and the finance minister delivered. Now, it’s the Reserve Bank of India’s (RBI’s) turn to chime in.  

The central bank is widely expected to cut the policy rate this week, the first such move in almost four years. The chorus for a rate cut stems from the need to boost mass consumption, rekindle animal spirits in the corporate sector, and jump start the investment cycle. With inflation showing signs of moderation and the path towards 4 per cent becoming visible, the space for the RBI to do so is clearly present.  

But monetary policy decisions are complex and there is merit in assessing the “right time” while weighing the cost and benefits of such moves.  

The recent calm in the currency market has proved to be temporary, with the rupee crossing the 87 handle this week as Trump delivered on some of his tariff threats. How other countries would respond and whether the global economy is moving towards a full-blown tariff war remains uncertain. Clearly, the wind is against us, and so could a rate cut now end up adding more fuel to the fire?  

Conventional macro theory suggests that a high-interest rate differential acts as a support for the local currency by increasing return on investments and attracting capital flows. At a time when the US central bank seems to be in no hurry to cut its policy rate, lower interest rates in India could compress the interest rate differential and further weigh on rupee. The India – US interest rate differential is already lower at 200-250 basis points (bps) compared to historical averages of close to 400 bps, as the US central bank had sharply raised rates in recent years.  

It’s true that given the significant overvaluation in the rupee, there is a need for it to depreciate further. However, a more digestible pace of rupee depreciation is perhaps warranted. Any sudden/sharp fall in the currency could further necessitate forex dollar sales by the RBI and act as a drain on domestic rupee liquidity. In this case, a rate cut could then end up tightening monetary conditions, defeating the initial intent of monetary accommodation.  

But one needs to weigh this “rupee risk” against the gains from a rate cut. 

It has been argued that the RBI must focus on domestic imperatives that warrant a rate cut instead of letting external factors dominate monetary decisions. Undoubtedly, the growth and inflation parameters warrant more accommodative monetary policy.  

What kind of accommodation might work better now is the question.  

For a rate cut to be effective, liquidity conditions must be comfortable in order to enable transmission through the economy to boost demand and investments. As of last week, system liquidity deficit was above Rs 2 trillion. This could limit and delay the initial boost from a rate cut to the economy. 

The RBI has responded with durable liquidity infusion measures of close to Rs 1.5 trillion including buying bonds (open market operations), conducting buy/sell swaps and longer duration repo operations in recent days. However, clearly there is a need to do more as the drag from forex interventions continues. A durable increase in liquidity — perhaps through a CRR cut — could prove to be more effective.  

A liquidity shot is what the economy needs.  

This would also help compliment the intentions laid out by the budget of crowding-in private investments and increasing investment growth in the economy. A revival in the private capex cycle would in part hinge on the availability of sufficient funds – essentially implying a higher level of credit growth than the current range of 11-12 per cent. For this, money supply created by the RBI would have to increase as more “durable” money in the system effectively raises banks’ ability to increase credit growth. In this regard, RBI’s reserve money growth has been significantly lower than historical trends — at 7 per cent as of 10 January, lower than the average during the last decade of over 10 per cent.  

The MPC has its work cut out as the RBI balances global headwinds with domestic compulsions. The hope is for the RBI to optimise the timing and nature of its policy response.  

The writer is principal economist at HDFC Bank