Fed Pause Gives RBI Breathing Room As Malhotra Weighs Next Move

The Monetary Policy Committee's first rate cut in five years in early February raised hopes of a series of reductions through 2025. For sure, the MPC took a unanimous decision to pencil a 25-basis-point cut in policy repo rate that came on the heels of a 4-2 decision in December to maintain status quo, Governor Sanjay Malhotra was emphatic that the MPC remained unambiguously focused on a durable alignment of inflation with the target while supporting growth. 

As is widely known, the decision—best described as satisficing—was taken amid growth concerns that fell well short of the Panglossian official outlook.

There appeared to be a near consensus that one of the reasons for the dip in growth was ‘high interest rates’ that impeded investment, credit offtake and the resultant economic activity. 

Under such circumstances it was also natural to expect that the rate cuts will gradually continue till interest rates reach a level where credit offtake would be smooth, private corporate investments would pick up and so would the economy – irrespective of how sensitive credit would be to interest rates even as there has been an excess capacity in the system and that in the absence of sufficient private corporate investments, it was the government expenditure that did deliver growth. 

No questions were asked whether it was the interest rates policy or the regulatory policy (both formal and informal) that restricted credit – even if such regulatory policies were aimed at restricting credit in the name of ensuring financial stability.

Now that we are a couple of weeks away from the next MPC deliberations to deliver their decision, the “markets” are speculating whether it would be a shallow 50-75 basis cut cycle through 2025, as was expected, or a deeper 100-125 bps one. 

If the issue is economic expansion through reduction of borrowing cost, then one has to remember that in a floating rate regime a single cut may not have that much of elasticity in terms of credit growth compared to say a somewhat clear interest rate pathway. But, given current global uncertainty, such pathway will be difficult to forecast. In such a case, what will a rate cut achieve other than some Treasury gains for banks and income for traders apart from running the risk of possible policy reversals if emerging situation demands?

While growth indeed is important, more work is needed to establish that growth was affected by high interest rates and not by non-rate related policies and developments. This is not to deny the relationship between cost of money and credit/investment, but from a financial stability angle shouldn’t the impact of geopolitics and trade/tariff wars on emerging market currencies especially on the rupee, amidst FPI selling of stocks on a large scale and RBI’s short dollar positions at $78 billion as per the RBI bulletin as of Jan 31, 2025 (Mar 19, 2025), be crucial issues? Hence RBI’s decisions can’t be in isolation and the FOMC decision would have a large bearing at this juncture.

Meanwhile the US Fed stayed put with its rate decision even as Powell appeared to have had no clue as to how the future course of rate decisions evolve through 2025. There has been so much of uncertainty as to how the US policies on trade, immigration and government spending would evolve even as the dust is yet to settle so that one can see stuff through the noise. 

When Powell said “I don’t know anyone who has a lot of confidence in their forecast”, it was very much possible that the Fed, going ahead, may cut, hike or stay put on federal funds target rate – depending on how the layoffs and immigration policies impinge upon the unemployment rate, how much the US government is going to save on the fiscal front (going by what the new administration says), and how the trade policies along with immigration policies affect price situation – though he underplayed the inflation concerns at this juncture saying the “base case” on price increases due to tariffs might be transitory. 

He also downplayed the University of Michigan’s projections of a sharp rise in long run inflation expectations. With higher inflation and lower growth projections there appears that Fed officials smell stagflation this year. As if that is not enough to the prevailing uncertainty, Trump’s Truth Social post, subsequent to FOMC decision to stay put with the rates, nudged the Fed to lower rates.
Given this background, at this point is there such an exigency as it was ahead of February policy that the RBI should go ahead with rate cuts in quick succession or to preserve the ammunition and to pause and go slow – that would mean skipping rate cut in the April policy? Afterall, some banks raised even overnight rate benchmark linked to borrowing, post last policy decision to cut rates by 25 bps (so much for transmission). 

Recall Alan Greenspan’s speech of January 2004 Risk and Uncertainty in Monetary Policy: “…the conduct of monetary policy in the United States has come to involve, at its core, crucial elements of risk management. In essence, the risk management approach to monetary policymaking is an application of Bayesian decision-making…As the transcripts of FOMC meetings attest, making monetary policy is an especially humbling activity. In hindsight, the paths of inflation, real output, stock prices and exchange rates may have seemed preordained, but no such insight existed as we experienced it at the time”. 

It would also be pertinent to remember, if not all the 10, but a few of those unspoken principles of Alan Greenspan as summarised by Alan Blinder et el., in their “Understanding the Greenspan Standard”. Keep one’s options open, especially when the economy changes far too much and too fast, for conventional econometric tools ever to pin down its structure with any accuracy and for this reason committing to a rule for monetary policy or even to a fixed response to a specific shock is too dangerous (principle 1). Not to let oneself get trapped in doctrinal straitjackets (principle 2). Avoid policy reversals (principle 3) and, that forecasts and models though necessary are unreliable (principle 4)

And as one of the said principles say one cannot afford policy reversals too soon, given we are in a period of radical uncertainty in Trump’s second term. At this juncture it would be premature to expect aggressive rate cuts without guessing the number of cuts and their size through 2025. One can wait; and the Fed decision is timely and helpful to RBI if it wants to wait.

It may be timely to examine whether a nuanced sophistication can be brought into the way RBI operates its monetary policy objectives through its tools.

1.    The governor recently urged the banks to lend more in call money market. The unsecured overnight market has, over the years shrunk drastically relative to collateralised borrowing, thanks to policy push to move participants from uncollateralised market to collateralised one. Yet, it is (the weighted average call rate) RBI’s operating target. In fact, the wider 50 bps corridor (which otherwise could have been narrowed down as in the case of Fed funds rate), of SDF to MFS is due to the narrower participation in call money market. One reason why banks are reluctant probably could be that this is viewed as negative liquidity scenario – making it somewhat akin to banks in the US avoiding the Fed discount window. Policy needs to change this perception.

2.    Is it time that we allow non-bank participation to place money with the RBI, as is the case in the US as non-banks are allowed to participate in ON RRP, so that the lower part of the corridor can be better protected and, overall systemic liquidity better managed and not fragmented?

3.    There is a possibility of bringing nuanced sophistication to RBI market operations as the current way of operating through multiple channels is often confusing – especially if the objective is to guide the interest rates, what matters is the overnight rate. As on today, RBI has two outstanding short term VRR of 3 days and 5 days, both having 6.26% as cut off. But since interest is charged at the end, it gives RBI operations a downward sloping trajectory. For shorter tenors, it is very small but as with RBI operations during covid, when such inflexibility on rates were on repos of fairly longer tenor, such slope is not insignificant. Why not keep the rate at repo rate and charge based on daily compounding?

4.    There also are occasions where it appears that the RBI is trying to control both the price and quantity of money, even as its liquidity management operations are to complement its rate decision. Oftentimes it appears that they are operated on two distinct unrelated ways. For instance, keeping amount and rate variable in VRR operations is introducing further uncertainty in the policy framework

5.    It is also possible that through non-bank participation in reverse repo one can address the current constraint to keep the system liquidity in deficit so as to ensure the sanctity of the corridor. A narrower operating corridor makes overnight rate swings more predictable allowing a smoother term curve. In a regime where rate increment is in 25 bps parcel, should Repo /SDF corridor be wider than that? Any liquidity swing can simply do away with the supposed policy rate movement. 

6.    May be, it is time we looked for a structure which is relatively resilient at least on the overnight tenor. The policy of operating by keeping the system liquidity in deficit mode at all times needs a review. Liquidity deficit will have ripple effects across the term curve. In deficit, corridor is assured but if deficit management is through instrument like VRR, it brings another new rate into picture which by operation has been outside the SDF-REPO corridor so far.