RBI’s Balancing Act
Context:
In his first monetary policy announcement, the Reserve Bank of India (RBI) Governor highlighted the effectiveness of the flexible inflation targeting (FIT) regime, the need to balance new regulatory measures with their cost, and ensuring adequate liquidity in the financial system.
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- The Monetary Policy Committee (MPC) responded to the economic environment by cutting the repo rate by 25 basis points (bps) to support growth while maintaining a neutral stance.
About Monetary Policy Committee (MPC)
The MPC is responsible for setting India’s benchmark interest rates to manage inflation while keeping economic growth in mind. The current target is 4% annual inflation until March 31, 2026, with an upper tolerance of 6% and a lower tolerance of 2%. The MPC was formed under Section 45ZB of the Reserve Bank of India (RBI) Act, 1934, and came into force on June 27, 2016. The amendment to the RBI Act in 2016 gave a statutory basis for the committee. The MPC has six members: Governor of the RBI (ex officio chairperson), Deputy Governor in charge of monetary policy, One officer of the Bank nominated by the Central Board and Three members appointed by the Central Government. The MPC meets at least four times a year and publishes its decisions after each meeting. A quorum of four members is required for a meeting. Each member has one vote, and decisions are made by a majority. The Governor has a second or casting vote in the event of a tie.
Growth and Inflation Outlook
- Growth Forecast: The RBI revised its GDP growth forecast for FY26 to 6.7%, down from 7.1% in October but in line with the December projection.
- This revision reflects concerns over slowing urban consumption.
- Income Tax Reductions: However, the governor remains optimistic, citing the recent income tax reductions in the Union Budget as a stimulus for consumption and investment.
- Additionally, a strong rural sector and robust agricultural production are expected to support growth.
- Inflation: On the inflation front, the RBI slightly increased its projection for FY26 to 4.2% from 4.1% in October and 3.8% in December.
- This upward revision is attributed to a weaker rupee and rising global commodity prices, which are expected to pass through to domestic consumers with a lag.
- While food inflation, primarily driven by soaring vegetable prices (26.3% this year), is moderating, core inflation is expected to rise from its current lows in 2024-25.
Rationale Behind the Rate Cut and Neutral Stance
- Evolving Balance: The evolving balance between growth and inflation provided room for the MPC to unanimously vote for a repo rate cut.
- However, the stance was kept neutral, contrary to market expectations of a shift to an accommodative stance.
- The primary reason for maintaining a neutral stance is the volatility in global financial markets and trade uncertainties.
- INR vs. Dollar: Since the last policy announcement, the Indian Rupee (INR) has depreciated by 3.2% against the US Dollar (USD), while the USD has strengthened by 1.5% against a broader basket of currencies.
- Asian currencies have been under pressure since October 2024, following the US elections and expectations of higher tariffs on China. The INR has followed this trend.
- Global Markets: Although the US Dollar index has softened slightly after President Trump postponed tariffs on Mexico and Canada, global markets remain on edge due to tariff threats, the US fiscal deficit, and expectations of prolonged higher interest rates by the Federal Reserve.
Liquidity Management and Regulatory Measures
- Ahead of the policy announcement, the RBI had already infused ₹1.5 lakh crore in liquidity through open market purchases on January 27.
- Consequently, no additional liquidity measures were introduced in this policy.
- With a neutral stance, the RBI aims to maintain liquidity at an optimal level, ensuring neither surplus nor shortage.
- However, if foreign portfolio investment (FPI) outflows increase, further liquidity measures may be required.
- Going forward, the RBI may use open market operations (OMOs) to neutralise the impact of maturing securities and inject durable liquidity, considering a moderate balance-of-payments surplus.
- Other tools, such as a reduction in the cash reserve ratio (CRR), buy-sell swaps, and longer-tenor variable repo rates, could also be employed.
Regulatory Reforms and Their Impact
- As a banking regulator, the RBI emphasised the need to strike a balance between financial stability and regulatory costs while improving efficiency.
- Notably, the implementation of key regulatory measures, such as the new liquidity coverage ratio (LCR) and expected credit loss (ECL) framework, will be phased in gradually.
Market Reactions and Future Outlook
- Following the policy announcement, India’s 10-year bond yield rose, while the rupee strengthened against the dollar.
- Market participants anticipate another rate cut in April, which is expected to keep bond yields in the 6.6-6.75% range in the near term.
- However, the rupee remains vulnerable to depreciation due to continued FPI outflows, trade uncertainties, and elevated US bond yields.
- While a reversal in this trend is expected, its timing remains uncertain.
The RBI’s first monetary policy under the new governor carefully balanced the need for economic growth with inflation concerns and global uncertainties. Going forward, the RBI is likely to focus on managing liquidity, addressing financial stability concerns, and navigating an increasingly complex global economic environment.
