A fiscally prudent, consumption-oriented Union Budget is behind us. That was the first act of a two-act drama typically staged every February. The scene now shifts from Parliament House in New Delhi to Mint Road in Mumbai, where the Indian central bank is headquartered. The second act of the drama will be played here on Friday when the policy-making body of the Reserve Bank of India (RBI), the Monetary Policy Committee (MPC), ends its three-day meeting, the last of the current financial year.<\/p>\n
Since the Budget has not deviated from the fiscal consolidation path, should the RBI allow\u00a0easing\u00a0\u00a0of the monetary policy? As a curtain-raiser, on January 27, the RBI announced infusion of Rs 1.5 trillion in the system through different instruments in a staggered manner: A government bond buyback worth Rs 60,000 crore in three tranches; Rs 50,000 crore variable rate repo auctions for 56 days; and a $5 billion dollar-rupee buy-sell swap for six months.<\/p>\n
The liquidity deficit in the system around that time was a little over Rs 3 trillion. It has since come down. Last Friday, the liquidity deficit was around Rs 2.2 trillion<\/p>\n
In its December policy, the RBI had cut the banks\u2019 cash reserve ratio (CRR), or the money that commercial banks keep with the central bank, by half a percent to infuse Rs 1.16 trillion. Will it follow up on the liquidity easing measures by cutting the policy rate this week?<\/p>\n
First, let\u2019s look at what global central banks are doing.<\/p>\n
At its last policy meeting on January 29, the US Federal Reserve left its key lending rate unchanged, resisting pressure from President Donald Trump to continue with rate cuts. The Fed paused after three consecutive rate cuts that lowered its key lending rate by a full percentage point, to 4.25-4.5 per cent. Federal Reserve Chair Jerome Powell has indicated that the US central bank does not need to rush to adjust interest rates as the unemployment rate has stabilised, the labour market conditions are solid and inflation remains \u201csomewhat elevated\u201d.<\/p>\n
The Bank of England (BoE) will make its first interest rate decision of 2025 a day ahead of the RBI\u2019s policy announcement. Analysts are expecting yet another rate cut since economic signals haven\u2019t been strong and services inflation has fallen substantially since the last meeting in December when three members of BoE\u2019s Monetary Policy Committee had voted for a rate cut to 4.5 per cent. After the second rate cut in November, BoE decided to keep the policy rate on hold at 4.75 per cent in December.<\/p>\n
Last week, the European Central Bank (ECB) cut interest rates yet again, by a quarter per cent to 2.75 per cent, and hinted at a further reduction in March as the slowing economy has been a bigger concern than persistent inflation. The ECB has been quite liberal in cutting rates to inject growth in the economy; this was the ECB\u2019s fifth rate cut since June.<\/p>\n
How is the scene in India? The gross domestic product (GDP) growth in the world\u2019s fastest growing major economy dropped to 5.4 per cent in the second quarter of the current financial year. Following this, in the December policy, the RBI pared its GDP growth projection for FY25 to 6.6 per cent \u2013 sharply down from 7.2 per cent. The government\u2019s estimate for growth is even lower \u2013 6.4 per cent.<\/p>\n
The December policy also raised the estimate for the consumer price index (CPI) inflation from 4.5 per cent to 4.8 per cent. In December, the CPI eased to 5.22 per cent from 5.48 per cent in November, the lowest in four months, largely driven by softening food inflation.<\/p>\n
The RBI\u2019s flexible inflation target is 4 per cent, with a 2 percentage point band on either side.<\/p>\n
At this point, it seems that for the government growth losing pace is a bigger concern than the CPI level. The finance ministry\u2019s monthly economic report in December says so, partially blaming the RBI \u2013 the combination of the monetary policy\u2019s stance and the central bank\u2019s macro-prudential measures as well as structural factors may have contributed to the slowdown in demand.<\/p>\n
There is merit in the clamour for a rate cut, but the joker in the pack is the local currency.\u00a0The rupee has depreciated from 84.6975 a dollar on December 6, when the last policy was announced,\u00a0to 86.6050 a dollar last Friday, after dropping to 86.70 on January 14.<\/p>\n
There has been substantial erosion in India\u2019s foreign exchange reserve between\u00a0the last week of\u00a0September and now \u2013 from $704.9 billion to $629.557 billion (on January 24). The combination of dollar sale by the RBI to prevent a sharp fall in the rupee and the erosion in valuation in other foreign currencies in the basket vis-\u00e0-vis dollar has contributed to this drop.<\/p>\n
Until recently, we saw controlled movement of the rupee. This was possible as the current account deficit was low, forex reserves were comfortable, and the balance of payment situation was okay. That encouraged the RBI to believe that it could engineer a low-volatility environment.<\/p>\n
Even after the dollar started strengthening and cracks started appearing in growth, the RBI did not change the policy. Foreign portfolio investors were moving out even as many of the importers kept their dollar position unhedged. In essence, the RBI was intervening against the movement by selling dollars aggressively offshore.<\/p>\n
Should it allow the rupee to find its own level or continue to sell dollars to manage the volatility in the forex market?<\/p>\n
Should it cut the policy rate to support growth despite a weakening currency?<\/p>\n
Indonesia’s central bank has done so. It cut policy rates on January 15, resuming its monetary easing to prop up growth in what is Southeast Asia\u2019s largest economy, despite financial market volatility that has sharply weakened the rupiah, its local currency. Of course, Indonesia\u2019s inflation is low.<\/p>\n
In India,\u00a0rate cuts alone will not serve the purpose, unless coupled with measures to infuse liquidity in the system, which can be done in multiple ways \u2013 through open market operations, or OMOs (RBI buying bonds from banks); longer term repo operation; dollar buy-sell swaps;\u00a0and further reduction in CRR.<\/p>\n
Can the RBI cut the rate and infuse liquidity to fuel growth when the currency is under pressure? It can, if it is convinced that the adjustment in the rupee valuation has already been done and the local currency has found its own level. One way of looking at this is that if we allow orderly adjustment of the rupee, outflow will stop and, at the second stage, inflow will start.<\/p>\n
At the December meeting, two of the MPC members \u2013 Nagesh Kumar and Ram Singh \u2013 pitched for a quarter\u00a0per cent\u00a0rate cut. There is no reason for them to change their position, except for the sharp depreciation of the rupee. It will be interesting to see whether any of the remaining four join their camp. Even if one MPC member joins them, it will be three-all. In such a situation, the RBI governor has the right to give the casting vote to decide on the policy. After the December policy, there has been a change of guard at the RBI.<\/p>\n
My take is there\u2019s a 50:50 chance of a rate cut.\u00a0The RBI can go for a cut. If it doesn’t, it will continue with\u00a0measures to infuse liquidity, signalling a new cycle. Once\u00a0the central bank\u00a0is convinced that the currency has found its own level, it will go for the rate cut. That can happen as early as April.<\/p>\n
This column first appeared in Business Standard.<\/em><\/strong><\/p>\n The writer, Consulting Editor with Business Standard and Senior Adviser to Jana Small Finance Bank, writes Banker’s Trust every Monday in Business Standard.<\/em><\/strong><\/p>\n