 |
|
The Reserve Bank of India's (RBI) aspirations to implement interest rate cuts are facing significant headwinds due to the uncertainty created by tariffs, particularly the Trump-era tariffs, referred to in the article as 'T2.' In a scenario devoid of these trade barriers, the members of the Monetary Policy Committee (MPC), convening this week, would likely have celebrated the easing of inflation and signaled the commencement of a downward cycle in interest rates. However, the current global economic climate, heavily influenced by trade disputes and protectionist measures, has effectively taken this option off the table. The RBI has been patiently awaiting a sustained cooling of retail prices, hoping to see inflation consistently align with its 4% target. A glimmer of hope emerged in February when the rate-setting panel decided to cut rates for the first time in five years, marking a potentially positive shift in monetary policy. Unfortunately, this optimistic outlook has been overshadowed by the ongoing tariff war, which is casting a long shadow over the economic landscape and creating substantial challenges for policymakers. The initial decline in the Consumer Price Index (CPI) to 3.61% in February from 4.26% in January, driven by reduced pressures on food prices, had initially positioned the MPC to acknowledge this positive trajectory with an interest rate cut. However, the MPC is now grappling with a multitude of complex and interconnected issues, including the looming threat of stagflation, a significant economic slowdown, the potential for capital flight, increasing financial instability, and a volatile currency, not to mention the ever-present risk of a global markets crash. These factors collectively create a highly uncertain and challenging environment for monetary policy decision-making. In previous decades, when economies and financial market cycles exhibited a greater degree of predictability, central banks found it relatively straightforward to make interest rate decisions. Markets often engaged in excessive risk-taking, secure in the belief that regulators would intervene to bail them out in the interest of safeguarding the broader economy. However, the current situation is testing this faith to its limits. The majority of crises witnessed in recent decades were triggered by market excesses, for which central banks had developed sophisticated models and established guideposts to manage the fallout. But the present 'T2' crisis presents a unique set of challenges that defy conventional approaches. The article suggests that if any historical precedent exists, it is the Smoot-Hawley Tariff Act, enacted in the United States in 1930. Many economists attribute this act to exacerbating the Great Depression and causing a precipitous decline in global trade, exceeding 50%.
However, unlike the economic landscape of the 1930s, where trade was the central focus of economic decision-making, the challenges of the 21st century are characterized by unprecedented levels of capital flows between nations. This adds another layer of complexity to the situation. A central bank must now contend with the daunting task of accurately forecasting inflation in a world disrupted by tariffs. While existing models are generally equipped to factor in domestic prices, global commodity trends, and core inflation rates, there is significant doubt about the existence of robust models capable of effectively assessing the wide-ranging impact of tariffs. While tariffs may contribute to rising prices in the United States, China, in response, could choose to dump goods in India, potentially leading to lower prices for consumers there, even if such actions are detrimental to domestic industries. This creates a complex and unpredictable situation for policymakers. Economists, including Jerome Powell, Chairman of the Federal Reserve, have generally agreed that tariffs will lead to higher prices and slower economic growth. However, few possess a comprehensive understanding of the full extent of their impact. Historically, the US Federal Reserve has typically lowered interest rates whenever economic growth slowed or the economy faced the prospect of recession. However, the current scenario presents a dilemma: what if the economy experiences stagflation, a situation characterized by both slow growth and high inflation, which would effectively prevent the Fed from lowering interest rates? The RBI may also find its actions constrained by similar considerations, as the decisions of the US Federal Reserve invariably influence global interest rates. A March 2025 Bank for International Settlements (BIS) working paper, entitled 'Monetary policy and the secular decline in long-term interest rates: A global perspective,' highlights the significant impact of US rate actions compared to those of other central banks. The paper states that changes in long-term bond yields in FOMC (Federal Open Market Committee) announcement windows account for almost 70% of the total decline in the 10-year yields of Australia, Canada, the euro area, Norway, New Zealand, Sweden, and the US. The report adds that other central banks' announcements generally do not produce any persistent effects on long-term interest rates.
India, characterized by a persistent current account deficit, relies heavily on capital inflows to sustain its economic growth. The returns generated from various asset classes, especially sovereign bonds, play a critical role in attracting foreign investment. Consequently, even if domestic prices were to create an environment conducive to rate cuts, the need to maintain healthy capital inflows will likely constrain the RBI's ability to act decisively. The interest rate differential between the US and India has narrowed substantially over time. The yield differential between the US and Indian benchmark bonds currently stands at 260 basis points, a significant decline from 600 basis points a decade ago. According to data from Bank of Baroda, this differential is well below the 5-year average of 450 basis points. This shrinking gap has already prompted international investors to sell off Indian equities, putting downward pressure on the rupee. A sharp reduction in interest rates could further exacerbate this trend, leading to a sell-off in bonds, which the country can ill afford. Given these complex and interconnected factors, the RBI may be compelled to adopt a prolonged pause on interest rates and explore alternative tools to mitigate potential financial market instability, particularly in the currency market. In this environment, cross-currency movements, such as those against the renminbi, could become increasingly crucial to monitor and manage. Despite the challenges, there remains some hope for the commencement of a rate cut cycle, although this hope is not predicated solely on the easing of inflation. The RBI may have to rely on a combination of strategic measures and perhaps a degree of optimism, waiting for the Federal Reserve to take action to avert a deep recession. The situation is complex, and the path forward is uncertain, requiring careful navigation and a flexible approach to monetary policy.