Liquidity Alone Can’t Lift Growth Without Confidence, Structural Reform

The Reserve Bank of India has pumped ₹2.5 trillion into the banking system through a surprise 50 basis points cut in the policy repo rate and a steep 100 basis points reduction in the cash reserve ratio. Bond markets cheered. Lenders gained. Yet the economy barely stirs. 

From a monetarist lens, this policy cocktail looks less like a bold stimulus and more like liquidity without traction.

Monetarist theory, rooted in Milton Friedman's work, holds that inflation and output respond to money supply with a lag, typically 6 to 12 months. By that yardstick, the RBI’s easing is premature, even risky. 

With headline inflation at 3.17%, below the 4% target, the Monetary Policy Committee appears to be leaning into the disinflation trend. But if the economy’s deeper constraint is weak demand and falling money velocity, this monetary stimulus may prove ineffective or even destabilising in the medium term.

This is not theoretical alarmism. India’s credit transmission remains patchy, with recent rate cuts doing little to unlock private investment or stoke consumption. The underlying problem is that financial institutions remain cautious, corporates are not investing aggressively, and households are wary. 

In such conditions, liquidity injections either sit idle or inflate asset prices, classic symptoms of a liquidity trap. Monetarists would argue that supply-side rigidities, not interest rates, are the true bottlenecks.

The velocity of money has been soft over the past decade, exacerbated by post-pandemic risk aversion, digitisation, and structural deleveraging. Lower cash usage and preference for financial savings have reduced the marginal impact of incremental liquidity. Unlike textbook expectations, more money does not mean more spending.

Fiscal Fog
This is where monetary theory collides with fiscal pragmatism. The Centre is pushing ahead with a large public capex programme despite fiscal constraints. The latest RBI moves, if seen as easing the government’s borrowing costs or accommodating deficit spending, risk crossing into fiscal dominance territory. 

Monetarists would caution that this blurring of roles undermines the RBI’s institutional independence and threatens future inflation expectations.

The danger lies not in short-term deficit financing but in the perception that monetary policy is now serving fiscal objectives. If markets suspect the RBI is monetising the deficit, longer-term bond yields could rise, defeating the purpose of the rate cuts. 

Worse, it could destabilise the currency.

India’s aggressive easing contrasts with the cautious stance of global peers. The US Federal Reserve has paused, not pivoted. The European Central Bank remains preoccupied with inflation. China, though cutting selectively, does so with an eye on currency stability. 

In contrast, India’s wide rate cut alongside CRR easing reduces interest rate differentials, weakening the rupee’s carry appeal. Already, the forward premium on the rupee has slipped, signalling declining appetite for the rupee-carry trades. A weaker currency amplifies imported inflation risks, especially with oil prices volatile and food inflation sticky. If capital inflows reverse or portfolio investors retreat, RBI’s easing cycle could be interrupted by market turbulence.

A monetarist approach would urge the RBI to wait. Rate cuts must not precede confidence.

Ultimately, surplus liquidity cannot substitute for weak confidence. With private investment tepid, consumption recovery uneven, and credit flow constrained, monetary easing lacks traction. A monetarist would argue that the multiplier effects are impaired, not absent. They need need structural repair.

Rather than rely solely on liquidity instruments, the RBI could champion targeted refinancing for MSMEs and infrastructure, alongside reforms to unclog transmission bottlenecks. Most crucially, the separation between monetary and fiscal spheres must be reasserted.

Because if markets believe that liquidity today is just debt monetisation by another name, they will price in inflation and currency weakness tomorrow.

Without structural confidence and transmission reform, this liquidity push risks becoming a monetary mirage.

(Views expressed are personal)