Extraordinary times often demand out-of-the-box responses, even if the ensuing results can remain chained to the vagaries of serendipity.
In the early 1970s, UK’s Chancellor of the Exchequer Anthony Barber made a “dash for growth” that involved easy terms of credit in lockstep with monetary easing and massive tax cuts, abandoning fixed exchange rates that saw the sterling slump around 15% over the next 18 months. In March 1973, the interest rates were slashed by a massive 75 basis points (bps) (8.5 to 7.75) even with the GDP clocking 12.5%. The railroad, however, fizzled as an unanticipated oil shock triggered inflation to skyrocket and a miners’ strike reversed the process.
Rate cuts backfired as the Asia crisis hit hard
Bank Indonesia (BI), during June 1995 to March 1997, cut the key BI rate five times even when the GDP was looking quite robust. Caught on the wrong foot in the Asian crisis, growth pummelled to a record low of -13% in 1998.
In present terms, the closest India can think of cutting rates in a benign inflationary rate regime, even when growth is high, would be China’s easing of rate by 25 bps in mid-2015 when inflation was marked decisively low at 1.4% (though the GDP data came days after the rate decision) and its own playbook stretching from June 2015 to September 2016, when policy rates were cut by 25, 50 and 25 bps with inflation remaining within the framework (5.40-4.20%).
This prelude was necessary as the monetary policy decision made by the Reserve Bank of India (RBI) on Friday—to cut 25 bps—was precisely negotiating this dilemma. The high GDP figure in Q2 at 8.2% implied that the full-year GDP growth for FY26 in RBI forecast stands at 7.30%, resulting in an output gap of 30 bps if we assume the potential growth at 7%. If we assume the potential growth in the post-Covid-19 period is still lower, the output gap is much wider.
On the inflation side, the RBI has reduced inflation projection for FY26 to 2.0% from the October estimate of 2.6% and February estimate of 4.2%. The Q1FY27 estimates are now lower by around 100 bps to 3.9%, from 4.9% put out in June. Q3FY26 estimates in February, at 3.8%, now stands at 0.6% according to the new forecast. We forecast inflation for FY26 at 1.8% and for FY27 at 3.4%. With such unprecedented level of downward revisions and further prospects of downward revision looming large, the RBI has kept the door ajar for future rate decisions. However, for now, the repo rate at 5.25% will be lower for longer.
In fact, the Indian situation is at variance with most of the other economies that are experiencing below potential growth and low inflation, suggesting a rate cut or pause. India’s situation is just the opposite as explained earlier, and the current divergence may continue for some time which will have its implications in terms of headroom for further cuts.
The RBI has, as expected, has announced liquidity enhancement measures through open market operations of around `1 lakh crore and buy-sell (B/S) swaps of $5 billion/`44,500 crore.
The situation of the rupee deserves careful consideration in the overall outlook on policy with analysis suggesting a 5% depreciation of the currency impacts inflation by ~30 bps. The current USD/INR non-deliverable forward premium remains elevated above the normal rate differential, and the hedging position needs closer monitoring to align the rupee’s trajectory.
Move may lower forward premiums
The RBI’s decision for a higher B/S swap could also ease the pressure on hedging. B/S swaps have historically led to a fall in the Mumbai Interbank Forward Offer Rate by lowering forward premiums, making overseas borrowing more attractive, and reduced hedging costs for Indian companies. It also helps inject durable rupee liquidity into the banking system, which can drive down interbank funding costs. The RBI’s clear differentiation of its distinct, though at times overlapping, measures aimed at durable and transient liquidity management should come as a confidence-building measure for broader markets.
While the market players (through banks) are provided with liquidity injections and the central bank replenishes its reserves, corporate asset liability management mismatches are also taken care of through hedging due to the liquidity-rich feature of Fx swaps that come in handy for corporates that have availed of longer tenor external commercial borrowings.
Jerome Powell, in late 2023, stressed the importance of a central bank’s dilemma of having clarity on what it is not doing, emphasising that the Federal Reserve is not and will not be a “climate policymaker”, while exhorting banks to understand and manage (climate-related) risks. It is not the Fed’s role to tell banks which businesses they can and cannot lend to, and this guidance is not intended to do so. The guidance clearly articulates this fundamental principle—an important addition to the proposal.
Against this background, the RBI has done its best to ensure monetary policy continues to support growth through a bouquet of measures. In all, with the 25 bps cut in the policy repo rate and by keeping the stance neutral, the monetary policy trajectory appears to be entering a phase of pause with neutral stance. The low inflation, positive output gap dilemma will ensure that the headroom will shrink in FY27, and policy may remain in wait and watch mode for a while. This works well in the overall uncertain environment for India as policy uncertainty is minimised, given the confidence to both domestic and foreign agents.
As Gabriel García Márquez wrote, “the heart’s memory eliminates the bad and magnifies the good, and (that) thanks to this artifice, we manage to endure the burden of the past.” A central bank can often be uber-pragmatic and envisage things that eventually ring-fence the burdens of the past while revitalising future drivers of growth.
The author is part-time member, 16th Finance Commission, part-time member, Economic Advisory Council to the Prime Minister, and Group Chief Economic Advisor, SBI
Views are personal
