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The Reserve Bank of India (RBI) is grappling with a complex economic landscape as it prepares for its monetary policy committee (MPC) meeting. Growth has slowed, headline retail inflation remains high despite recent softening, and the global environment presents significant challenges. Emerging market currencies are under pressure due to geopolitical volatility, a strong US dollar, and the actions of other central banks. While the US Federal Reserve has paused rate cuts, the European Central Bank, Bank of England, and the Bank of Canada continue to ease monetary policy. Even Indonesia, despite a weakening Rupiah, recently cut rates to stimulate growth. This global context significantly impacts the RBI's decision-making process.
Domestically, the picture is mixed. Headline CPI inflation averaged 5.6% in Q3 2024-25, but this is largely driven by items outside the direct control of monetary policy, such as vegetables and precious metals. Other key inflation indicators, including WPI, core-WPI, core-CPI, and GDP deflators, show considerably softer readings, averaging between 1% and 3.5%. This divergence suggests that while headline inflation is elevated, underlying inflationary pressures are subdued. The RBI projects CPI inflation to average 4.4% over the next nine months, creating a conundrum for the MPC: whether to prioritize the recent high retail inflation figures or trust the forecast of benign future inflation. The decision in February appears to be a close call, highlighting the difficulties inherent in navigating such a complex situation.
Despite the uncertainty regarding interest rate cuts, liquidity support has become a clear priority for the RBI. A contraction in system liquidity, with a daily average deficit exceeding ₹1.5 trillion since early December, necessitates immediate action. The RBI's recent announcements, including measures like an OMO calendar, 56-day repo, and FX swaps, are projected to inject around ₹1.5 trillion into the system in the coming weeks, in addition to the ongoing large VRR operations. However, the RBI's intervention in the foreign exchange market remains a significant factor influencing banking system liquidity. India experienced nearly $20 billion in net foreign institutional investor (FII) outflows over the past four months, primarily from the equity market. This outflow is attributed to uncertain global macro-dynamics, a recalibration of expectations regarding future US policy rate cuts, and anticipation of a weak earnings season.
The RBI's emphasis on liquidity support is also rooted in the recent decline in reserve money growth. Since mid-2022, the compounded annual growth rate (CAGR) of reserve money—the primary measure of liquidity infusion—has fallen sharply to around 7%, contrasting with the long-term average of 12-15%. A stronger growth in reserve money is essential to bolster durable liquidity in the banking system, supporting healthy credit growth for productive sectors. The disciplined Union Budget and the RBI's significant step-up in liquidity measures have increased expectations for a rate cut. However, strong arguments exist on both sides of the rate action debate. A persistent large liquidity deficit could hinder the effectiveness of rate cut transmission, potentially prompting the RBI to prioritize further liquidity support while adopting a wait-and-see approach on interest rates, especially given the pressure on the Indian Rupee (INR). However, maintaining a hawkish stance and pausing on rate cuts could worsen the existing growth slowdown.
In conclusion, while a rate cut in February remains uncertain, the RBI is firmly committed to providing liquidity support to the banking system, exploring all available tools. The upcoming meeting holds significant importance as it will be the third for three of the six MPC members and the first for the governor. The MPC's actions and statements will serve as a critical reference point and guide monetary policy decisions in the months ahead. The decision will be a complex balancing act between managing inflation and supporting economic growth in the face of considerable global and domestic uncertainty. The implications will be far-reaching, impacting businesses, consumers, and the overall health of the Indian economy.
The author, Siddhartha Sanyal, Chief Economist & Head of Research at Bandhan Bank, acknowledges the contributions of Sudarshan Bhattacharjee and Gaurav Mukherjee. It's vital to understand that the views expressed are personal and do not necessarily reflect the official stance of Bandhan Bank or any other institution.
Source: Liquidity support is priority; rate cut a close call