Change is a time for renewed vigour. But it is also important to build on major past lessons. Three such are especially relevant to guide the new Monetary Policy Committee in the current global turmoil. The first is the required level of the real repo rate, the second is the importance of keeping core liquidity in surplus and the third is how to react to exchange rate volatility.
The real repo rate
Salient changes in the last two months for the MPC to consider are headline inflation falling within the tolerance band and towards the target as expected. Market expectation for January is 4.6 per cent and 4 per cent for the year, so current as well as forward looking real repo rate is above 2 per cent. Such a real rate contributed to the current growth and investment slowdown, just as it did in the 2010s.
These episodes underline the interest sensitivity of Indian aggregate demand, which research also supports. Policy needs to internalise this. Corporate results have largely reflected the slowdown that set in after six months of high repo rates and tight liquidity. Real policy rates have been high for more than a year now. Their continuance is dangerous since monetary policy acts with a lag.
Fiscal consolidation has exceeded expectations. The underlying growth assumptions are also conservative. There is an emphasis on agriculture as the first growth engine with action proposed on vegetable supply chains. All this should provide comfort to the MPC.
It is argued that since the Budget provides stimulus the MPC need not do so. The Budget will trigger demand from different categories with continuing growth in capex, welfare transfers for non-income taxpayers and large tax cuts for lower rungs of middle-class taxpayers with high consumption propensities. But a falling fiscal deficit ratio implies net demand from the government is reducing. Monetary policy therefore has to stimulate aggregate demand. It has the space and one of the best instruments — the real interest rate that affects consumption and investment decisions. A real policy rate of around unity is essential for sustained recovery.
Liquidity injection
It is also argued that liquidity is more important than rates and must be in surplus before a rate cut can be transmitted. But the RBI’s recent liquidity injection despite continued dollar outflows shows they have the tools if the intent is there. In a neutral stance, they are free to inject as required. Extended periods of tight durable liquidity over the past year raised short rates above the repo and aggravated the slowdown, although short term liquidity adjusts endogenously through the liquidity adjustment facility (LAF). But only banks can access the LAF window. In a regime of instant withdrawals, they are not comfortable lending when long term or core liquidity is in deficit. Moreover, our markets are still subject to large exogenous liquidity shocks from foreign flows, cash leakages or changes in government cash management.
Pending structural reform such as more inter-bank lending and liquidity windows for a far more diversified set of financial market participants, it may be good for the RBI to plan to keep durable liquidity in surplus. The surplus may be marginal when monetary policy is tight and more substantial when it is accommodative. This will require anticipating or at least responding quickly, to shocks that drain durable liquidity.
Exchange rate volatility
The main concern behind recent calls for a status quo in rates seems to be fear of global volatility. But it is important to smooth external shocks, not aggravate them by squeezing domestic demand as well. Trumps unpredictability should not be allowed to drive the Indian economy. The post pandemic period showed we have the degrees of freedom to set interest rates to suit our domestic cycle.
Analysts who were first asking the RBI to let the rupee go, now want to tie the repo rate to defend the rupee. But the MoU with the government has no mention of exchange rates. Under inflation targeting, the policy rate cannot be used for an interest rate defence.
In any case it does not work in Indian conditions where high growth attracts FPI more than high interest rates that squeeze growth. There were more inflows when our interest differential with the US was narrowest in 2023. It has widened with 1 per cent of Fed rate cuts in 2024.
So the MPC can and should do nothing about the exchange rate. The interest rate has to be set based on domestic inflation and growth profiles.
But the RBI has multiple instruments which it can and should use to reduce excess volatility and persistent real deviation of the exchange rate. Outflows can be used opportunistically to achieve the required depreciation, while reserves prevent over-depreciation and are rebuilt during inflows. Some volatility is good for price discovery, to induce hedging and inoculate markets from fear of change.
Analysts were similarly worried during outflows and reserve depletion after the Ukraine war broke out. But reserves were rebuilt. Outcomes were similar in many past periods of global risk-off.
Our analysts’ dilemma illustrates why this kind of intervention is essential. In advanced economies (AEs) the nominal exchange rate tends to revert to trend after overshooting, but in emerging markets fears of persistent depreciation set in leading to calls to raise interest rates.
A vicious cycle of falling growth and further outflows can set in. Research shows that it is EMs (emerging markets) with the buffers to craft independent policy that do well.
In AEs floats accompany inflation targeting and free the MPC from considering exchange rates. In EMs it is managed exchange rate flexibility and intervention that does so. Exchange rate adjustments driven entirely by external shocks can be too much, or in the wrong direction.
The argument that depreciation itself stimulated demand, so no rate cut is required, is also not correct in Indian conditions. Exports are largely competitive, with limited ability to pass on price increases, while dominant oil imports instantly become more expensive, so over time the result is inflation and real appreciation. Persistent real appreciation does hurt exports and has to be avoided.
It follows that at least a 25 basis point cut is required. Rate cuts are delayed and there is space for more cuts, but slow and steady is best in rocky times. Doing nothing is the worst choice.
The writer was a member of the previous MPC. This article builds on her comments as chair of the EGROW Shadow Monetary Policy Committee