RBI has done its part, solutions to external disruptions lie elsewhere

Analysts and economists in financial markets were debating over the past few weeks whether the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will be in a position to reduce the policy repo rate further. A poll published by this newspaper earlier this week showed that some analysts expected the MPC to reduce the policy repo rate by 25 basis points in the August meeting. However, the six-member MPC on Wednesday unanimously decided to leave the policy rate unchanged at 5.5 per cent. The commentary accompanying this prudent decision clearly indicated that, as things stand, the committee may not be able to reduce the policy repo rate any further in this cycle. Hopes in the market had arisen after the June inflation numbers surprised on the downside and led to a downward revision in annual inflation forecasts.

 

The MPC also reduced its inflation projection for this financial year from 3.7 per cent to 3.1 per cent, which is significantly lower than the target of 4 per cent. However, there were several reasons for a prudent central bank not to reduce the policy rate in the present circumstances. First, monetary policy needs to be forward-looking. Therefore, while the inflation projection for this financial year has been revised lower, the inflation rate in the fourth quarter is projected at 4.4 per cent. It is further expected to increase to 4.9 per cent in the first quarter of 2026-27. Thus, given that the inflation rate is expected to be much higher than the target in the coming quarters and will substantially reduce the real policy rate, it would not have been prudent to lower the policy rate further.

 

Second, the lower headline inflation rate is being driven by volatile food prices, particularly prices of vegetables. The core inflation rate was at 4.4 per cent in June. A reversal in food prices would also affect the headline rate. Third, the MPC had front-loaded the rate intervention, which is still working through the system. Fourth, the MPC has not revised its growth projection. It expects the Indian economy to grow 6.5 per cent this financial year. The growth rate for the first quarter of 2026-27 has been estimated at 6.6 per cent. Given the growth and inflation projections for the first quarter of 2026-27, it is difficult to argue for a rate cut at this stage. Besides, given the level of uncertainty, it is always better to avoid any policy adventurism. In the context of the trade, which is the biggest source of economic uncertainty, United States President Donald Trump on Wednesday decided to impose an additional ad valorem duty of 25 per cent on Indian imports as a penalty for importing crude oil from Russia. This development and related uncertainties in the system will affect the growth and inflation outlook, depending on how they settle and when.

 

Apart from the monetary-policy decision, RBI Governor Sanjay Malhotra talked about liquidity management. The RBI has injected a significant amount of liquidity in recent months. The decision to reduce the cash reserve ratio by 100 basis points in June, to be implemented in four tranches, will further increase liquidity in the system. The RBI was absorbing excess liquidity worth over ~3 trillion daily, on average, in July. Easy liquidity conditions have helped monetary-policy transmission. However, as the transmission nears completion, the RBI needs to guide market expectations on liquidity, along with gauging possible unintended consequences. In terms of supporting growth, the RBI has done its bit and solutions to disruption induced by the external environment need to be found elsewhere.