MPC Signals Maturity as Policy Counters Shocks with Confidence

The MPC decision demonstrates the maturing of Indian policymaking. The traditional emerging market response is to tighten in volatile times. What we have, instead, are the correct countercyclical moves based on the domestic cycle. Policy is countering the impact of shocks on the economy, instead of aggravating them. The growing depth and diversity of the economy make this feasible. The view that there is a lot of uncertainty, so it is better to ‘wait and see’, is the old-style precautionary tightening against shocks. But keeping space often means wasting space.

There was clear space, and the repo rate at 5.5% was incompatible with flexible inflation targeting. Since the 1970s, whenever ex-post real headline inflation-adjusted rates persisted around 2%, growth slowed.  Real rates matter for demand and have been high for more than a year now, since the RBI has been over-forecasting inflation since mid-2024. It has had to continuously bring forecasts down by large amounts, but has now moved beyond base effects and acknowledged that core or trend inflation has been low for a long time, so that headline inflation is likely to anchor near the target.

The MPC has also been appropriately forward-looking in basing its decision on expected future growth rather than current outperformance. July-September growth came in at 8.2%, but inflation below target implies growth is still below potential.

The reversal of the fiscal-financial tightening, and some repo rate cuts, had helped the turnaround from the 5.6% growth dip in the second quarter of the last fiscal year, despite US tariffs.  But signs show slowing growth, not overheating, after the October GST boost. Core industry growth, manufacturing IIP and PMI have fallen, and urban unemployment is higher at 7%. The US trade agreement is still pending. Exports are slowing, further reducing demand. Required counters are stimulating domestic demand, along with increasing diversity in export destinations.  

The government has stimulated demand through front-loaded spending and tax cuts. But its fiscal consolidation path limits the stimulus it can provide. Its contribution to aggregate demand is actually shrinking as it cuts the fiscal deficit, although a better quality of expenditure has reduced costs throughout the economy and stimulated private consumption. But a restrictive monetary policy will, over time, mitigate these effects. The government might then be forced to raise deficits. Sustaining fiscal conservatism, which has brought down risk premia, requires monetary coordination.

Pass-through
The change to a neutral stance with hawkish language in June weakened the pass-through of repo rate cuts despite a double cut. Since 10-year government bond rates went up, peaking at 6.57% at the end of October, banks did not need to reduce loan rates to compete. Pre-policy, it was 6.53%. The cut, while retaining the neutral stance, will help convince markets that rate cuts are possible in such a stance, especially since growth-induced tax buoyancy will allow the government to keep to its consolidation path despite tax cuts. The communication now is also that data-dependent cuts are possible.

Retaining the neutral stance is correct since if very low inflation does not persist, there is no room for multiple further cuts. The effect of the base changes expected next year has to be seen. Future cuts are possible, but not certain.

The OMOs announced will also help pass through. Banks wanted liquidity, not rate cuts, although their profitability is high despite some margin squeeze.  The CRR cuts and rising credit demand have protected profitability. They have the space to compete for deposits as credit-deposit ratios rise, perhaps reducing deposit rates less than loan rates. Indian bank margins remain among the highest in the world. Income raises savings while rates affect their allocation. Rising household financial savings suggest there is room, in a growing economy, for alternative savings avenues.

Moreover, even if loan rates do not fall much, it does not mean there is no pass-through, and cuts are wasted. The cut may prevent loan rates from rising as demand increases. Loans linked to external benchmarks will be reduced, but many borrowers are complaining that their rates have not been cut. Steady surplus liquidity, as well as lower SDF rates, will force banks to earn more from funds available.

External Stability
The OMO injections are required to counter the draining of liquidity due to FX operations and demonstrate that RBI has both the tools and the intent to keep liquidity adequately in surplus. Buy/sell swaps allow intervention to support the INR without draining liquidity.   

The exchange rate is not in the MPC’s mandate. Indeed, a full float is supposed to accompany canonical inflation targeting. But a full float is not feasible in EMs since it creates excess volatility, raises risk premia and borrowing rates. It hurts small exporters who have too little market power to gain from depreciation. Over-depreciation soon raises inflation in an import-dependent economy, resulting in real appreciation. Markets also want volatility, but not too much. Therefore, most EMs have a managed float. They build reserve buffers as insurance and to smooth volatility.  

The mention of swaps while communicating the MPC decision, although it is positioned as a liquidity management tool, is a subtle hint that the RBI is very much there in FX markets, to prevent excess volatility and persistent misalignment.

Defending a particular nominal value leads markets to take positions around it. So, intervention has to be strategic and non-predictable. A REER of about 100 has worked well for the economy, and research shows it to still be the equilibrium value. It has now depreciated to near 90 and is likely to revert with help from the RBI, if necessary. There is enough confidence now to let it overshoot temporarily, to perhaps help counter the tariff for some exporters.

The position this policy takes is that financial stability will come from confidence, not from fear.