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The Reserve Bank of India (RBI) finds itself in a precarious situation where its aspirations for cutting interest rates are being severely hampered by the ongoing trade war, primarily driven by US tariff policies. The Monetary Policy Committee (MPC), responsible for setting interest rates, would ideally be considering a rate cut given the cooling inflation rates. However, the uncertainties introduced by the trade war, particularly the imposition of tariffs, have effectively taken this option off the table. The RBI has patiently awaited a sustained moderation in retail prices, aiming to comfortably meet its 4% inflation target. A glimmer of hope appeared in February when the rate-setting panel implemented its first rate cut in five years, signaling a potential easing cycle. This optimism, however, has been overshadowed by the pervasive impact of the trade war, casting a long shadow over the economic outlook. The situation is further complicated by a confluence of other challenges, including the threat of stagflation, economic slowdown, capital flight, financial instability, and a volatile currency. These factors, combined with the potential for a global market crash, create a highly uncertain environment for the central bank.
For decades, central banks operated within a relatively predictable framework, allowing them to make interest rate decisions with a degree of confidence. Market excesses were often tolerated with the expectation that regulators would intervene to provide a safety net, safeguarding the broader economy. However, the current crisis, characterized by the imposition of tariffs, presents a unique set of challenges that existing models and playbooks are ill-equipped to address. The closest historical parallel is the Smoot-Hawley Tariff Act of 1930 in the US, which many economists believe exacerbated the Great Depression, leading to a dramatic decline in global trade. While trade was a central consideration in the 1930s, the challenges of the 21st century are more complex, driven by unprecedented capital flows between nations. A central bank must now contend with inflation forecasts that are influenced not only by domestic prices, global commodities, and core inflation trends, but also by the unpredictable effects of wide-ranging tariffs. While tariffs may lead to higher prices in the US, China could potentially respond by dumping goods in India, resulting in lower prices, even if it negatively impacts domestic industries. The complexities of this dynamic make it exceedingly difficult to accurately assess the overall impact on inflation and economic growth.
Economists, including Jerome Powell, Chairman of the US Federal Reserve, broadly agree that tariffs are likely to lead to higher prices and slower economic growth. However, quantifying these effects remains a significant challenge. Historically, the US Fed has responded to economic slowdowns or recessions by lowering interest rates. However, the possibility of stagflation, a combination of slow growth and high inflation, complicates this traditional response. In a stagflationary environment, lowering interest rates could exacerbate inflation, while raising rates could further depress economic growth. The RBI faces a similar dilemma, as its actions are constrained by the policies of the US Federal Reserve, which significantly influence global interest rates. A Bank for International Settlements (BIS) working paper from March 2025, titled 'Monetary policy and the secular decline in long-term interest rates: A global perspective,' highlights the significant impact of US rate actions on global bond yields. The study found that changes in long-term bond yields in Federal Open Market Committee (FOMC) announcement windows accounted for nearly 70% of the total decline in 10-year yields in several major economies, including Australia, Canada, the euro area, Norway, New Zealand, Sweden, and the US. This underscores the substantial influence of US monetary policy on global financial markets.
India, with its persistent current account deficit, relies heavily on capital flows to sustain its economy. The returns generated by various asset classes, particularly sovereign bonds, play a crucial role in attracting these capital flows. Even if domestic prices warrant a rate cut, the need to maintain capital inflows will likely constrain the RBI's actions. The interest rate differential between the US and India has narrowed considerably over time. The yield differential between the US and India benchmark bonds is currently around 260 basis points, down from 600 basis points a decade ago, and well below the five-year average of 450 basis points, according to Bank of Baroda data. International investors are already selling off Indian equities, putting downward pressure on the rupee. A sharp reduction in interest rates could trigger a further sell-off in bonds, which India can ill afford. Given these challenges, the RBI may be forced to adopt a long pause on interest rate cuts and instead explore alternative tools to address potential financial market instability, particularly in the currency market. Cross-currency movements, especially against the renminbi, could become increasingly important. While there remains hope for a future rate cut cycle, it is unlikely to be driven solely by easing inflation. The RBI may have to rely on a combination of careful analysis and strategic interventions, awaiting signals from the US Federal Reserve that could prevent a deep recession.