Policy adjustment: RBI rate cut prudent move in face of global uncertainty

In a world with heightened uncertainties, the six-member monetary policy committee (MPC) of the Reserve Bank of India (RBI) did well not to increase them further. As widely expected by the financial markets, the MPC on Wednesday unanimously decided to cut the policy repo rate by 25 basis points to 6 per cent. It also decided to change the policy stance from “neutral” to “accommodative”, which effectively means, barring an economic shock, the possibility of increasing the policy repo rate is off the table. The MPC in its upcoming meetings will only deliberate the possibility of cutting the policy rate or maintaining the status quo. The change in policy stance, along with several liquidity measures taken in the recent past by the RBI, should improve the pace of policy transmission.

 

Although uncertainties in the global economy have increased significantly because of a sharp increase in tariffs by the United States, the decision for MPC this week was fairly straightforward. The consumer price index-based inflation rate has come down, largely because of a decline in the food inflation rate, and is expected to remain close to the RBI’s medium-term target of 4 per cent. The RBI lowered the inflation projection for this financial year from 4.2 per cent to 4 per cent — the rate is expected to remain below target in the first three quarters this financial year. Given the possibility of much slower global growth owing to trade tensions and the fact that the US has virtually shut out Chinese imports, there would be downward pressure on prices in the rest of the world. Prices of crude oil and other commodities have declined significantly in recent days. Higher tariffs on Indian exports to the US, along with broader uncertainties, will affect growth in India as well. The RBI has lowered its growth projection by 20 basis points for the year to 6.5 per cent. In the circumstances, it’s reasonable to assume the possibility of the growth projection getting revised lower will be high.

 

In terms of rate action in the future, assuming the current inflation projections hold, there would be space for a maximum easing of 25-50 basis points. However, these are not normal times. The global economy is dealing with the biggest trade shock in post-war history and it is hard to say when things will stabilise and what the state of the global economic order will be. For Indian monetary policy, while domestic prices are likely to remain stable, risks could emerge from the pressure on the currency. Although projections by professional forecasters, featured in the latest Monetary Policy Report — also released on Wednesday — show that India’s current account deficit in the ongoing year will be about 1 per cent of gross domestic product, which is considered moderate, global incertitude could still lead to financing challenges. Both long-term and portfolio investors may be reluctant to commit capital in the given circumstances.

 

It is also likely that the inflation rate in the US will increase because of higher tariffs, which may not allow the Federal Reserve to ease monetary policy as expected earlier. A possibility of policy tightening, which cannot be ruled out, will further complicate matters for India on the currency front. Although rupee depreciation will benefit India and negate some impact of higher tariffs, it could increase the inflation rate. In sum, a number of moving parts in this unpredictable environment will demand agility on the part of the central bank. Financial markets would also be better off not pricing in large rate cuts because of possible pressure on growth.