On the conclusion of its fifth bi-monthly meeting this fiscal on December 6, 2024, the Monetary Policy Committee (MPC) decided with a 4-2 majority to keep the policy repo rate unchanged at 6.50 per cent, i.e., eleven times in a row. The stance of the policy was also kept unchanged at ‘neutral’. This decision was unanimous. Most of the surveys conducted before the policy meeting indicated continuance of the status quo with regard to both the policy rate and stance. Expectedly, a few of the responses were similar to the dissent opinions within MPC that favoured a rate cut by 25 basis points.

Also, in line with the majority responses in the surveys, the RBI announced a favourable liquidity measure: it decided to reduce the cash reserve ratio (CRR) of all banks by 50 basis points, thereby restoring it to 4 per cent of NDTL, which was prevailing before the commencement of the last policy tightening cycle in April, 2022. Release of primary liquidity to the banks as a consequence of this step would be about ₹1.16 lakh crore, boosting their resources for making loans and investments.

Adaptive projections?

Two recent data significantly altered the macroeconomic prospects and, by implication, the expected path of the monetary policy for the rest of the current fiscal as also the next one: (i) CPI print for October 2024 at 6.2 per cent exceeded the upper tolerance level of 6 per cent, and was also way above the latest Q3:2024-25 projection of 4.8 per cent, and (ii) real GDP growth for Q2:2024-25 at 5.4 per cent was much lower than the latest projection of 7 per cent, Q1:2024-25 actual of 6.7 per cent and 8.1 per cent registered in Q2:2023-24.

In the light of the two data, the MPC has reduced the GDP growth projection for 2024-25 from 7.2 per cent to 6.6 per cent and increased CPI projection for 2024-25 to 4.8 per cent from 4.5 per cent made earlier. These are large adjustments happening within a period of about two months, which would raise two questions: One, why, in general, the actual prints with respect to both GDP and CPI happen to be worse than the projections? As a corollary to this: Is there any systematic bias in the quarterly projections? Two, to what extent are the projections also adaptive? Getting answers to both these questions is important, as they will provide an insight into the robustness of the models used in the RBI for the purpose of making macroeconomic projections for monetary policy purposes.

The number of dissenting members of MPC who favour a commencement of policy easing with a rate cut by 25 basis points has now increased from one to two. Their line of argument seems to be the following: the recent slowdown in the growth rate as also in private investment in the manufacturing sector point to a demand deficit in the economy, which has been compounded by a lacklustre demand for industrial products in India’s export markets. Real exchange rate appreciation of the Indian rupee since the onset of the tightening cycle in May 2022 and thereafter has contributed to the poor overall export performance during this period. More real appreciation of the rupee is a possibility if the process of ‘normalisation of monetary policy’, involving reduction in the policy rate by MPC does not begin here and now.

The majority opinion, the essence of which has been articulated by RBI Governor Shaktikanta Das on several occasions in recent months, is that strong foundations for high growth can be secured only with durable price stability. Restoration of the balance between inflation and growth in the overall interest of the economy is the foremost task of the MPC. High inflation not only reduces the purchasing power of both rural and urban consumers but also alters relative prices. Both can have adverse implications for private consumption. Any premature cut in the policy rate, i.e., before durable alignment of CPI inflation with the 4 per cent target could lead to several macro-financial setbacks.

The higher-than-expected CPI print for October was occasioned by a sharp rise in food inflation and an uptick in core inflation. Any cut in the policy rate now may engender the risk of inflation getting out of control, requiring policy reversal and several doses of rate increases. Doing so will run against the very grain of the inflation-targeting framework now in place.

Turkey experience

The experience of Turkey in recent years highlights the likely mistakes in monetary policy-making in a succinct manner. In the wake of the outbreak of war in the Black Sea region in early 2022, Turkey faced a significant spurt in consumer inflation, like many other countries. The central bank there responded to this development with a very unconventional measure: it slashed the policy rates (the main ones being the central bank’s overnight borrowing/lending rates) thrice later that year. This action was based on the assumption that a lower interest rate would reduce the economy’s cost structure which, in turn, would reduce inflation and provide a boost to local industry, particularly the exporters. None of the anticipated outcomes materialised, though. The spike in inflation continued unabated, leading to a harsh policy reversal in early 2023. The central bank’s overnight borrowing rate rose from 7 per cent in February 2023 to 13.5 per cent in June 2023. Despite the tightening, consumer inflation in Turkey is still very high at around 47 per cent.

Monetary policy-making is not about looking for tactical opportunities and pretexts to cut the policy rate. This approach is likely to be costly in a macro-economic sense and could even be destabilising. The decision to develop a benchmark overnight interest rate to be called SORR (Secured Overnight Rupee Rate) and based on two secured overnight money market instruments (basket repo and TREP) is a timely step.

Over the last several years, there has been a continuous shift in volume from the unsecured overnight lending and borrowing market (with MIBOR as its benchmark) in favour of the secured market. And in the secured segment, TREP has been gaining in volume. Subsequent to the commencement of publication of SORR by FBIL, one would expect the emergence of SORR-based interest rate derivatives in India.

The writer is a former central banker and a consultant to the IMF. Through The Billion Press