Monetary Policy Review: RBI’s Interest Rate Cut Amid Accelerating Growth

Link: https://www.thehindu.com/opinion/editorial/prudent-action-on-rbi-interest-rate-cuts/article70372583.ece

Why in the News?

The Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) recently decided to cut interest rates once again by 25 basis points (bps), bringing the rate to 5.25%. This move is regarded as an assessment of India’s current economy and future expectations.

Background and Context: Policy Trend and Growth Trajectory

A comparison of the current rate cuts with a past episode provides context for the MPC’s decision-making process concerning the growth-inflation dynamic.

Cumulative Rate Cuts

• Total Reduction: Interest rates have been cut cumulatively by 125 basis points in the calendar year.
• Comparison to 2019: Similar large cuts (135 bps) were implemented in 2019; however, those cuts were in reaction to a plummeting growth rate (from 8.9% in March 2018 quarter to 3.3% by December 2019 quarter).

Current Growth Trajectory

• Opposite Trend: Growth is currently following the opposite trajectory, steadily accelerating from 5.6% in the second quarter (Q2) of the previous year to a recently released 8.2% in Q2 of the current year.

MPC’s Rationale for Rate Reduction

The rate cut, despite the seemingly strong Gross Domestic Product (GDP) numbers, suggests the MPC is operating under specific concerns and aims.

Growth Perspective Assessments

• Subdued Growth Conviction: Central bank is not convinced that growth is currently as robust as the numbers suggest, indicating monetary policy needs to be as supportive as possible.
• Excess Capacity and Investment: MPC feels that Indian companies are still sitting on excess capacity, making risks of overheating the economy slim and supporting a push for more growth.
• Underlying Reality: Reality is likely a combination of factors: real growth looks higher due to an unusually low deflator, and companies can afford to invest more, even if this is fuelled by debt. The rate cut is seen as addressing both issues.

External Factors and Economic Impact

• US Tariff Impact: MPC possibly feels that the economic impact of the U.S.’s 50% tariffs has not yet fully played out.
• Supply Chain Realignment: Supply chains take time to realign, suggesting there might be a further shift away from Indian exporters.
• Credit Support: Cheaper credit going ahead will be welcomed by Indian MSMEs, especially exporters.

Inflation Outlook and Prudent Stance

The MPC has revised its inflation outlook but remains cautious, maintaining a specific policy posture to allow for flexibility.

Inflation Outlook

• Lower Projection: Outlook for inflation for the year has been lowered to a benign 2%.
• Risk Factors: All calculations could be undone by a sudden jump in food prices or oil prices.

Prudent Policy Posture

• Neutral Stance: The decision to retain a neutral stance is considered prudent.
• Policy Pivot Necessity: Global uncertainty is such that growth and inflation trajectories could reverse direction suddenly, requiring a quick policy pivot (readiness to raise rates).

Historical Precedent (2019)

• Inflation Jump: The 2019 rate cut episode saw inflation jumping from 2% to 7.6% in about a year, highlighting the need for vigilance.

Way Forward

• Continuous Monitoring of Inflation Drivers: Priority needs to be placed on close monitoring of food and fuel prices, with particular attention to supply-side disruptions, so that emerging inflation pressures can be detected early and timely policy response can be executed before inflation expectations become unanchored.​
• Strengthening Policy Transmission and Credit Access: Emphasis needs to be placed on effective transmission of policy rate cuts to bank lending rates, especially for MSMEs and export-oriented sectors, so that intended growth support from cheaper credit is fully realised and not diluted by rigidities in financial system.​
• Integrating External Risk into Macro Strategy: Broader macroeconomic framework needs to incorporate trade shocks such as high foreign tariffs into growth and external sector planning, with focus on diversification of export markets, productivity improvements, and domestic competitiveness, thereby ensuring that monetary policy is not overburdened as sole adjustment instrument.​
• Maintaining Readiness for Swift Policy Pivot: Institutional capacity needs to be kept ready for rapid change in policy direction, including re-tightening if inflation spikes, or further easing if global or domestic shocks undermine growth, which justifies maintenance of neutral stance and flexible forward guidance.

Conclusion

• The Reserve Bank of India’s (RBI) latest interest rate cut is based on an assessment that India’s robust growth momentum needs additional support, given domestic factors like excess capacity and external risks like the impact of U.S. tariffs, while inflationary concerns are currently contained.
• However, the retention of a neutral policy stance is a prudent action, acknowledging the high degree of global uncertainty that could necessitate a swift change in the monetary policy direction to ensure macroeconomic stability.

UPSC MAINS PYQs

1. Explain the difference between the computing methodology of India’s Gross Domestic Product (GDP) before the year 2015 and after the year 2015. (2022)
2. Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons in support of your arguments. (2019)
3. Do you agree that the Indian economy has recently experienced a V-shaped recovery? Give reasons in support of your answer. (2021)
4. Define potential GDP and explain its determinants. What are the factors that have been inhibiting India from realizing its potential GDP? (2020)