US tariff turmoil: RBI MPC needs to gauge the effect of uncertainty

The policy environment for the six-member monetary policy committee (MPC) of the Reserve Bank of India (RBI), meeting this week for the first time this financial year, has become enormously complex owing to global uncertainties. Last week, the United States imposed reciprocal tariffs on all trading partners. A 10 per cent base tariff now applies to all countries. Besides, it has imposed additional tariffs on countries with a higher trade surplus. Imports from India, for instance, will attract a tariff of 26 per cent. China has been slapped with a reciprocal tariff of 34 per cent, which, after including the existing 20 per cent tariff, takes the rate to 54 per cent. China has retaliated swiftly by imposing a 34 per cent tariff on US imports. To what extent these US tariffs and possible retaliatory action by other large trading partners will affect the global trade flow or global growth is hard to gauge at this stage.

 

This is also being reflected in financial markets. Volatility has increased significantly and stock markets have fallen across the world. The Indian benchmark BSE Sensex, for instance, fell 2.95 per cent on Monday. The global crude oil prices have fallen, with benchmark Brent crude declining over 15 per cent thus far in April. The yield on the 10-year US government bond has fallen by about 25 basis points this month, which suggests financial markets expect the Federal Reserve to cut policy rates more aggressively. This would most likely happen with the possibility of the US economy slipping into a recession — the odds have increased significantly. Worse, this may happen with higher tariffs pushing up consumer prices in the US. As Federal Reserve Chairman Jerome Powell noted last week, the inflationary effect of tariffs could be persistent. A potential recession in the US economy, combined with the biggest global trade shock in the post-war era, could significantly reduce global growth.

 

The challenge for the MPC is to gauge how this heightened level of uncertainty will affect growth and inflation dynamics in India, which will form the basis of its policy decision. The resolution of the MPC and the accompanying commentary by key RBI officials will be keenly followed by financial markets on Wednesday. Nonetheless, as things stand, the MPC expects the consumer price index-based inflation rate to average 4.2 per cent this financial year, which is close to the central bank’s medium-term target. Since India’s exports have been subjected to higher tariffs, though lower than some of its Asian competitors’, it will affect output and growth. Although it’s still early days and the Indian government is negotiating a bilateral trade agreement with the US, assuming food inflation remains benign, slower growth could reduce pricing power for firms, leading to lower overall inflation. Besides, softer crude oil prices will also bring down the inflation rate. However, the Union government increased excise duty on petrol and diesel by ₹2 per litre on Monday, limiting the benefit.

 

Further, since higher tariffs in the US will reduce its import demand, excess global output could depress global prices, at least in the short run. It may also lead to some dislocation in global supply chains, which could push up prices but the exact impact would be hard to quantify. Thus, on balance, the MPC is likely to find enough reason to go for another 25-basis-point policy-rate cut. It would be interesting to see if it also revises its growth and inflation projections. However, from a medium-term perspective, it would be important for the MPC not to go into overly accommodative mode to support growth in case the trade shock has a higher impact than expected.