Why Arjuna’s Eye May Blink 

The Reserve Bank of India’s Monetary Policy Committee is expected to cut the repo rate by 25 basis points on Friday, with the groundwork seemingly laid for such a move. Yet, there remains a compelling case for the Committee to maintain the rate at 6.5%, where it has stood since February 2023.

The government has effectively shifted the responsibility to the RBI, arguing that fiscal space has been created for rate cuts through restrained revenue expenditure. Instead of opting for expansive spending, the Union Budget focused on targeted tax breaks aimed at stimulating consumption. This approach explicitly nudges the RBI to take the baton, beginning with a potential rate cut.

Historically, new appointments from the Ministry of Finance to the RBI often align with the ministry’s broader economic vision. The newly-appointed Governor, Sanjay Malhotra, may follow this trend. Recent policy actions suggest that the groundwork for easing has already been laid. Late last month, the RBI announced liquidity injections potentially amounting to ₹1.5 trillion, with plans for open market operations signalling a decisive shift towards printing primary money.

This announcement followed a 1₹-trillion liquidity release through a 50-basis-point cut in the cash reserve ratio in December. The first clear signal came in October when the MPC diluted its stance to neutral from tightening, which it euphemistically termed “withdrawal of accommodation”. 

Two MPC members favoured a rate cut in December, and the inclusion of two new RBI members, including the Governor, could tilt the balance further towards easing. In December, the RBI’s growth forecast for 2024-2025 was trimmed to 6.6%, with the MPC acknowledging the headwinds. Now, the Committee may find itself compelled to arrest the trend.

Although a rate cut seems imminent, strong arguments exist for holding steady. While inflation has moderated, with consumer price inflation easing to 5.22% in December from 5.48% in November, it remains above the 4% target. Projections suggest a further decline to 4.5-4.7% in January, but the RBI’s own outlook indicates that inflation will not reach the target before July to September of 2026.

The RBI could consider a reduction in the cash reserve ratio or continue with open-market bond purchases to support economic activity. 

External risks have also intensified. The rupee has depreciated over 4% since November, hitting a record low of 87.4975 against the dollar. This decline has been driven by foreign capital outflows and a sharp $34 billion drop since Nov 15 (and $75 billion from peak) in foreign exchange reserves before a modest recovery. The weaker currency raises concerns about imported inflation. A rate cut could exacerbate these pressures, potentially accelerating capital flight and weakening the rupee further.

Instead of a rate cut, the RBI could also consider another 50-basis-point reduction in the cash reserve ratio to inject liquidity. Continued open-market bond purchases could also support economic activity. This approach would signal that the RBI is prepared to lower the hurdle rate but is not yet rushing into it.

If the government remains disciplined in meeting its fiscal deficit targets, it should afford the RBI the same space to adhere to its inflation mandate. Amidst global uncertainty, maintaining a steady hand on interest rates may prove more beneficial than hastily deploying monetary easing.

Ultimately, the decision will rest on balancing domestic growth concerns with external vulnerabilities. It seems far easier to justify a rate cut than to argue for keeping the policy repo rate on hold.