Search for stability: RBI has done nearly all it can to steady economy

In a world of economic uncertainties, the Reserve Bank of India (RBI) last week made a bold attempt to provide the Indian financial system and economy at large some certainty. The monetary policy committee (MPC), in its second meeting of the financial year, decided to reduce the policy repo rate by 50 basis points to 5.5 per cent on Friday. The consensus in the market was for a 25-basis-point cut. The MPC clearly aimed to frontload policy accommodation to boost economic activities. With last week’s rate reduction, the MPC has reduced the policy repo rate by 100 basis points in the current cycle. Further, in addition to the larger than expected rate cut, the RBI decided to reduce the cash reserve ratio (CRR) by 100 basis points to 3 per cent, which will be implemented in four stages, adding durable liquidity worth ₹2.5 trillion to the system. 

It is expected to enhance the transmission of the policy-rate reduction and reduce the cost of funds for the banking system. The RBI has, in fact, taken several steps in recent months to provide adequate liquidity. It has infused liquidity worth ₹9.5 trillion since the beginning of the year. As a result, the weighted average call rate (WACR), the operational target of the monetary policy, was hovering at the lower end of the liquidity adjustment facility corridor. This also means that the actual policy accommodation has been higher than what the rate cuts suggest. The RBI will likely keep WACR at the lower end of the corridor to enable transmission of the latest rate cut. 

Notably, the MPC not only delivered a higher than expected rate cut but also clearly communicated to the market that “…under the current circumstances, monetary policy is left with very limited space to support growth”. To put it differently, the RBI has nearly done its part to support growth. It also changed the policy stance from “accommodative” to “neutral”, underscoring that the next policy action will not necessarily be a rate cut. This raises an important question for market participants: Has the MPC reached the terminal repo rate for this cycle? It is worth noting that the space for a bigger rate cut was created by moderation in the headline inflation rate. The inflation rate moderated to 3.2 per cent in April. The MPC also revised its inflation projection for the year from 4 per cent to 3.7 per cent. Some economists believe that actual inflation would be lower than the MPC’s projection. 

However, assuming the MPC’s projections hold, it expects the inflation rate to average a little over 4 per cent in the second half of the financial year. RBI economists have previously shown the neutral rate lies between 1.4 per cent and 1.9 per cent. Assuming the MPC works with this estimate and monetary policy needs to be forward-looking, the chances of further rate cuts are low. If inflation outcomes do surprise on the downside, it would open up space for more rate cuts, but it may not happen in the coming months. On the growth front, the MPC maintained its projection of 6.5 per cent, though it remains unclear to what extent it expects the policy rate cuts to stimulate growth. Given that growth last financial year was at the same level, policy intervention will need to go beyond monetary accommodation to sustainably increase the medium-term potential growth rate above 7 per cent.