Is RBI Navigating With An Outmoded Compass?

Amid stagnating real household incomes, declining corporate profits, and the threat of rising global protectionism, India’s official narrative—that its growth slowdown is merely a transient drag below a 7% potential real GDP—rings increasingly hollow. 

The fiscal toolkit deployed so far has included spending curbs and modest income tax cuts amounting to ₹1 trillion (0.4% of annual household income). Meanwhile, the Reserve Bank of India has resorted to rate cuts, hoping monetary easing will revive economic growth. However, this strategy presupposes that historical models still apply to a structurally altered economy. The problem lies in the RBI’s adherence to a monetary framework calibrated for a bygone era. 

As the Lucas critique, cited in the Expert Committee report on flexible inflation targeting in 2014, warned, past economic conditions may not reliably predict future outcomes. 

The central bank’s inflation-targeting regime anchors policy to a 4% CPI target (π*), with a 2-6% tolerance band, and a potential real GDP growth of over 7%. This is paired with an assumed neutral real interest rate (r*) of 1.4-1.9%, implying a neutral nominal policy rate of 5.4-5.9% (i*=r*+π*). Hence, the recent 6.5% policy rate and the current 6.25% repo rate are seen as restrictive—levels the government considers as “very stressful” and blameworthy for stifling growth. 

But here’s the problem: neutral policy rates (r* or i*) presume an economy operating at full capacity with near-zero savings-investment gap, stable external accounts, and inflation anchored at the desired level (π*). The current inflation target (π*=4%) is set with an upper range defined by the detrimental level of inflation, beyond which it is inimically harmful to the economy. The lower end of the range is the level that should be avoided for a deflationary bias. The neutral policy rate and the desirable inflation target create an incentive structure beneficial to both producers and consumers. 

However, India’s reality is starkly divergent. Inflation has consistently stayed above target, eight-quarter average current account deficit and trade deficit stand at 1.3% and 7% of GDP, respectively, and the rupee’s real effective exchange rate is overvalued. Private capex revival has remained elusive since 2012, and non-cyclical savings rate has been declining. These are symptomatic of declining productivity, resonating with rising disguised unemployment and dependence of workers on rural and agriculture occupations.

Real household consumption growth has slowed to a CAGR of 3.1% since 2011-12 (HCES 2023-24). With household debt at record highs, and government debt ballooning to ₹270 trillion in FY25E, crowding-out effects of higher tax incidence have stifled households. Despite high public sector investments, broader economic multipliers have yet to materialise.

 

Even the recent dip in CPI inflation to 4.3% in January 2025—driven by a seasonal drop in vegetable prices—offers little solace. The longer-term trend proves that the RBI's inflation-targeting framework has failed to deliver consistent results. Inflation’s stickiness reflects structural concerns: declining productivity and stagnant wages. Over the past two years, inflation has averaged 1.25% above the 4% target, hovering in the 4-6% range and the de-facto one standard deviation range has been +/-1% around 5.25%.

The dissonance exposes multiple flaws in the RBI’s framework: 

Potential GDP growth is likely lower than the assumed 7%, closer to the 3.5-4% growth in real household income, a significant portion of the GDP.

The 4% inflation target relies on outdated averages from two decades ago, ignoring today’s lower productivity and entrenched labour market slack, given the rising dependence on unproductive employment in rural areas. A 3% target may be more realistic.

The actual average real policy rate at 1.1% since late 2022 is significantly lower than the real neutral rate (r*) of 1.4-1.9%, as estimated by the RBI. The current levels are also lower than the pre-pandemic average of 2.2%. 

Given the decline in structural components of the savings rate, average inflation of 5% and the inflation target of 4% remain inimical. A recalibration of the desirable r* to 2%+ is imperative to revive savings amid protectionism induced restrained global capital inflows.

With inflation averaging 5%, the nominal policy rate should have been closer to 7% (πt plus r*=2%), higher than the 6.5% peak and the current 6.25%. 

Replacing the Compass 

The RBI’s insistence on accommodative policies, paradoxically framed as “restrictive” has only deepened the structural disequilibrium. Not only has the real rate persisted below our presumption of r* at 2.0-2.25%, but the RBI has also ensured comfortable liquidity in the system over the last decade despite anaemic deposit growth. Adopting an inflexible exchange rate regime over the past two years was also geared towards ensuring a favorable domestic market situation. 

The consequent accommodative financial conditions may have incubated speculative excesses — from asset price bubbles, especially in real estate, to equity valuations detached from earnings. The ₹76 trillion erosion in market capitalisation in Indian equities over the past six months—equivalent to 30% of annual household income—is a manifestation of prolonged overvaluation. It could lead to a contagion effect, risking financial instability. 

India’s policymakers must jettison outdated models and confront uncomfortable truths. Potential growth is lower, inflation remains sticky, and neutral rates are higher than assumed. RBI’s capitulation to demands for easing may be an attempt to prevent a full-blown bust. Without urgent recalibration, the RBI risks navigating the economy with a rusting compass.