Can The RBI Afford To Cut Rates?

The consensus in the financial markets, and indeed among all economy watchers, is that a cut in the repo rate in the February monetary policy is a done deal. However, there might be a contrarian, less popular view that might question its certainty.

The RBI will decide on rate action amid two recent and important economic developments –first the budget and second the commencement by the US of the much-feared trade wars with the imposition of high tariffs against its neighbours, Mexico and Canada, and then China.

The trading partners are not taking things lying down and retaliation has followed. Canada, for instance, slapped 25% tariffs on $107 billion worth of imports from the US. There is an uneasy truce with Mexico and Canada for now but China may follow with counter measures. The tariff war will not end here. President Trump has hinted at tariffs on goods from the European union. It is particularly alarming that he has both Brazil and India in his crosshairs as countries that protect their markets. 

One hopes that the temporary suspension of tariffs against the US’s neighbours augurs well for the future and is merely a negotiation tactic to secure both economic and non-economic gains for the US. However, for a President who had kept tariffs on top of his campaign agenda, it is difficult to foresee a scenario in which his pledge to protect the economy with tariff walls can be abandoned altogether.

Why should the RBI take this on board? Let’s take the budget first. First, the growth projections. The 10.1% nominal GDP growth assumed for 2025-2026 in the budget and the Economic Survey’s estimate of real growth of 6.3 -6.8% suggest the government believes that a slowdown that started in 2024-2025 (that clocked growth of 6.4% going by the advance estimates released in January) is likely to persist in 2025-2026. Thus, the economy needs a helping hand. 

Purists will argue that a reduction in the fiscal deficit is, by definition, contractionary, despite the bold tax cuts. The purist view is reflected in the claim that the tax stimulus is not enough – capital expenditure is frozen at last year’s budget-estimate, the lower non-tax-paying economic segments at the bottom of the income have been left out and so forth. Their verdict—the budget is not enough to stimulate growth. Monetary action should complement fiscal efforts.

The counterpoint stems from the composition of the fiscal strategy. The tax breaks for the middle class creates significant additional disposable income. The propensity to consume in these income categories is high and the result will be a push to consumer demand. Consumer companies, both for durables and non-durables, tired of holding their price-lines quarter after quarter, will push up margins by hiking prices. The result – rising inflation at a time when core inflation was showing signs of bottoming out. On the balance, the key question is: should the RBI pay heed to consumption-led inflation risk in deciding on the rate? Should it, instead brush it off, arguing that at this stage a little more inflation is a fair price to pay for the much-needed growth?

The bigger risk to a rate cut comes from the likely global tariff war that will drive inflation up across the board from energy to consumer products. This is unlikely to be a one-time increase. Higher prices of energy and other primary inputs on the back of tariffs will filter down to the prices of intermediate goods that will then stoke inflation pressures in final goods and services. Thus, a long-drawn global inflationary spiral seems imminent and India will not remain immune to this.

Besides, going by past experience, higher US tariffs push up the dollar and pull other currencies down. The rupee might be in for another bout of sharp depreciation. This will exacerbate imported inflation and also threaten financial stability. For example, foreign portfolio investors might ramp up sales if they fear that their dollar returns will be eroded by a weaker rupee. This will further erode forex reserves. 

The textbook defence for a currency under pressure is for the central bank to maintain, if not hike rates. Were the RBI to follow this prescription, they would want the so-called “carry” or interest differential between the US and India firmly in favour of India. A rate cut would do exactly the opposite

This does not mean that the RBI will never be able to cut rates. The choice that Mint Street’s mandarins face is whether to wait for the global political and policy uncertainties to subside a little before taking the rate call.

Can the RBI still help the economy if it desists from rate cuts? The problem, as most bankers are likely to point out, that has hurt the most over the last couple of years has been the wild swings in liquidity in the banking system with prolonged phases of high liquidity deficits. 

The liquidity deficit that determines all short-term money market rates reached a record high of ₹3.3 trillion on Jan 23. This followed the RBI’s intervention in the forex markets (the RBI takes back rupees from banks when it sells dollars) and tax outflows that transferred rupees from the banking system to the government’s accounts at the RBI. Both the shortage of liquidity and the uncertainty around it hamper the ability of banks to deliver credit.  

The RBI has recently responded through multiple modes including Open Market operations (OMOs) of ₹600 billion, buying government bonds back from banks and in the process, bolstering rupee balances of banks. More needs to be done so that the availability of money, the essential fuel for the economy, does not become a binding constraint for growth. The RBI would do well, in the upcoming policy, to tell banks what kind of system-wide liquidity balance it’s comfortable with, perhaps even give a calendar for open market operations.

As for a rate cut, it is a close call despite the clamour for it to come through.