RBI’s New Dharma: Bold Cuts, Balanced Stance

In what proved to be a rollercoaster policy speech that likely left even the most seasoned bond traders dizzy, Reserve Bank of India Governor Sanjay Malhotra did three key things. First, a clever tactical move to leverage the current phase of low inflation to frontload rate cuts through a big bazooka of 50 basis points instead of staggering the cuts over multiple policies.

Second, issuing a caveat that the central bank had not thrown caution to the winds and pivoted entirely towards growth. Hence, the switch back to a “neutral” stance and the message that the RBI was done with most of its heavy lifting in getting growth back on track. 

Third, with the cut in CRR by a hefty 100 basis points, the RBI reiterated the fact that liquidity remains the critical lever in the monetary machine to ensure better transmission of policy rate changes and push loan growth up from its somewhat moribund levels of around 10%.

The shift in stance back to “neutral” from “accommodative” has a couple of implications. For one thing, it brings data dependency back into the policy equation. This resonates with the first couple of paragraphs in the governor’s speech that highlighted the continued uncertainty, albeit somewhat reduced from the last meeting, on the global front. 

Creating the headroom to cut, hold or even hike the interest rate reintroduces the strategy of making future policy moves dependent on the flow of data and emerging risks. What could be the big risks going forward? One certainly stands out. Despite the current softness in key prices like that of oil and the general consensus that the global tariff wars are likely to induce recession, which going by the textbook is deflationary, the RBI has chosen the risk of supply-driven global inflation on its list of risks. Well done!

Second, a neutral stance might also be construed as the RBI’s reading of the neutral interest rate. This is broadly the rate at which growth and inflation find a steady state. If growth falters, the policy rate could be below neutral. If inflation perks up, it could be pushed above. This is also the rate at which interest of savers and borrowers align and find equilibrium. If one uses the repo rate and the RBI’s forward projections of inflation this would be in the range of 1.5% to 2%.

The staggered reduction in the CRR — commencing in early September — will provide succour to banks in the second half of the fiscal year, when liquidity tightens seasonally. This should help them plan better and not have to scrounge around for cash in times of a crunch, a phenomenon that had become commonplace last year. Better transmission, first through benchmark-linked loans that become cheaper and then a more gradual process of repricing deposits and other loans, is likely to follow. The key thing is that surplus liquidity is likely to make fundraising by banks easier, either through deposits or from the wholesale market. That should prevent sudden, sharp drops in net interest margins and help financial stability.

Governor Malhotra’s approach of “smoothing” liquidity, which, in effect, ensures a money supply growth compatible with its growth and inflation targets has been somewhat obfuscated by the attention given to policy rate changes and the MPC ritual that goes with it. This shift in liquidity stance from the previous regime that preferred to intervene through short term instruments rather than long term or durable liquidity deserves more praise. 

In fact, it is a rediscovery of what many central banking experts consider the monetary authority’s Dharma. In an influential paper written for the Bank of International Settlements in 2010, the much revered central banker Charles Goodhart wrote, “The essence of central banking lies in its power to create liquidity, by manipulating its own balance sheet... the corridor system could be so managed that liquidity policy and interest rate policy could be varied in a largely independent fashion.”

Will the 6.5% growth target be met? Will inflation overshoot the new forecast of 3.7%? The simple answer is that it’s hard to tell. Both growth and inflation rise on a number of factors that monetary policy has little control over. However, this is a policy that tries to play its limited role as well as possible and have a contingency plan in place, should things go wrong.