Policy space and stance: Inflation outlook will guide MPC's actions

The Reserve Bank of India (RBI) Governor Sanjay Malhotra, in an interview with this newspaper on Tuesday, said that if the inflation outlook turned out to be lower than the RBI’s expectations, it would open up policy space.  There was some confusion in the marketplace after the Monetary Policy Committee’s (MPC’s) latest policy action on June 6 to reduce the policy repo rate by 50 basis points to 5.5 per cent. The resolution of the committee had noted “... under the current circumstances, monetary policy is left with very limited space to support growth”. It also decided to change the stance from “accommodative” to “neutral”. A “neutral” stance essentially means that all options will be on the table. However, as Mr Malhotra explained in the interview, the change in stance does not mean an immediate reversal in the policy cycle. 

It is important to understand the rationale behind the MPC’s decision to reduce the policy rate by 50 basis points, as against the market expectation of 25 basis points. The MPC could have mechanically reduced the policy repo rate by 25 basis points and kept its stance as “accommodative”. It would not have perhaps resulted in much debate. Instead, the MPC decided to front-load the possible rate action and change the stance. Given that the MPC had the space to reduce the policy rate by 50 basis points, it made sense to do it in one go because monetary policy works with a lag. Since the MPC used the space available, it made little sense to keep the stance as “accommodative”. To support the MPC’s decision, the RBI also decided to reduce the cash reserve ratio by 100 basis points to 3 per cent, which will come into effect in four stages and infuse durable liquidity worth ₹2.5 trillion into the system. 

It is worth noting that the RBI has taken a number of steps to improve liquidity conditions since the beginning of the year. As a result, the weighted average call rate (WACR), the operational target of the monetary policy, was moving close to the lower end of the liquidity adjustment facility corridor. As Mr Malhotra noted, the RBI will continue to weigh the trade-offs between keeping the WACR closer to the lower end of the corridor to enable better transmission or align it with the policy repo rate. In the present circumstances, it would make sense to keep the WACR close to the lower end to facilitate policy transmission. 

In terms of future rate action, it is important to note that monetary policy needs to be forward-looking. Therefore, for policy purposes, inflation projections for the coming quarters are more relevant than last month’s reading. In this regard, the MPC expects the inflation rate to average 3.7 per cent this financial year. However, the rate is expected to be slightly above 4 per cent in the second half this financial year. Research by RBI economists has shown that the neutral rate (which theoretically neither stimulates nor restricts economic growth) lies between 1.4 per cent and 1.9 per cent. Assuming the MPC goes by it and maintains the real repo rate around this range, there won’t be scope for further rate cuts in the current cycle. However, it would not mean that the MPC will reverse the policy soon. Instead, it may maintain a prolonged pause. The space for further cuts might open up if the inflation projection is significantly revised lower, which some economists believe is a real possibility.