RBI's repo rate cut: The global environment will pose risks

The six-member monetary policy committee (MPC) of the Reserve Bank of India (RBI) in its last meeting of the financial year — the first after Governor Sanjay Malhotra took office — unanimously decided to reduce the policy repo rate by 25 basis points last week to 6.25 per cent. The rate decision, driven by lower inflation projections, was widely anticipated by market participants. The RBI expects the consumer price index-based inflation rate to average 4.2 per cent in 2025-26 — assuming a normal monsoon — compared to the projection of 4.8 per cent this financial year. Since monetary policy should be forward-looking and the inflation projection is close to the legally mandated target while growth has slowed, it made sense to make the monetary policy less restrictive.

 

However, as argued by this newspaper last week, given the uncertainty in the global environment—particularly stemming from the United States (US) with implications for inflation outcomes — the MPC could have waited for clarity before reducing the policy rate. Among other things, the imposition of tariffs on different countries by the US — or the threat of doing so — has resulted in a significant strengthening of the dollar. Other currencies, as a result, particularly in the emerging markets are under pressure. The rupee, for example, has depreciated by over 2 per cent since the beginning of 2025. Since the rupee is overvalued in real terms and is likely to continue depreciating, it will have implications for the prices of imported items. The October edition of the biannual Monetary Policy Report of the RBI noted that 5 per cent depreciation in the rupee over the baseline can push up the inflation rate by 35 basis points. The baseline exchange rate for the second half of this financial year was Rs 83.5 per dollar — the rupee currently is at 87.43.

 

Although the RBI says the inflation projections take into account rupee depreciation, sustained pressure because of global factors could pose upside risks. Besides, trade-related uncertainties could disrupt supply chains, which could have implications for inflation outcomes. Be that as it may, now that the RBI has eased, it is worth debating to what extent it can further reduce the policy rate, assuming the inflation projections hold. Recent research by economists at the RBI showed the estimate for the neutral rate was 1.4-1.9 per cent (Q4:2023-24). Accordingly, at around the midpoint of the range, the MPC can reduce the policy rate by another 50 basis points. However, the timing will depend on a variety of factors and global developments are likely to play a significant role.

 

Aside from the MPC decision, several other important announcements made by the RBI are also worth highlighting here. For instance, Mr Malhotra in his statement mentioned that the RBI would work on improving the forecasting of key macroeconomic variables. This must be welcomed because the conduct of the monetary policy depends on the accuracy of projections. The RBI had to scale back its gross domestic product growth projection this year significantly and expects the economy to expand 6.7 per cent in 2025-26. The governor also urged banks to trade among themselves in the money market instead of passively parking funds with the RBI. Such trade will improve the depth of the money market. The reluctance of banks often creates a liquidity mismatch in the system, warranting intervention by the RBI. Further, Mr Malhotra noted the RBI would attempt to balance the costs and benefits of regulation. In a relief to lenders, the proposed liquidity coverage ratio guidelines have been deferred.