Monetary Policy Expectations: A Balancing Act for the RBI

Highlights

• A repo rate cut is widely anticipated, with some market participants also expecting a CRR cut.
• Macroeconomic conditions have evolved significantly since the December policy, with inflation easing and growth indicators remaining subdued.
• While a rate cut is justified, a complete shift in policy stance may be premature.
• The rupee’s sharp depreciation poses a key risk, and further easing could accelerate capital outflows.
• Regulatory relaxations on liquidity and risk weights may provide relief, but excessive dovishness must be avoided.

Macroeconomic Context

The economic landscape has changed considerably since the last policy meeting in December. At that time, CPI inflation stood at 6.22 percent, exceeding the RBI’s 2-6 percent target range. However, inflation has since moderated to 5.2 percent in December, with projections indicating further softening to 4.5 percent in January. The outlook suggests that inflation will remain within the 4.0-4.5 percent range until September and potentially fall to 3.5 percent in the October-December quarter of 2025.

Given this inflation trajectory, a repo rate cut of 25 basis points—from 6.5 percent to 6.25 percent—is widely expected.

Rationale for a Rate Cut

Beyond inflation, growth concerns warrant monetary easing.

• GDP growth slowed to 5.4 percent in the second quarter of FY25, with subsequent indicators reflecting sluggish economic momentum.
• Auto sales from the top four manufacturers grew only 1.8 percent in January 2025.
• The services PMI declined to a two-year low of 56.5, down from 59.3 in December.
• Consumer demand remains weak, with companies such as Asian Paints, Dabur, and Symphony reporting low single-digit sales growth in the December quarter.
• NBFC credit growth has moderated, prompting calls to reverse the risk weight on bank loans to NBFCs, which was increased to 125 percent in November 2023.

Given these factors, corporate India is advocating for lower interest rates and easier liquidity conditions to stimulate demand and investment.

Risks of Rupee Depreciation

A key concern with monetary easing is the significant depreciation of the rupee.

• The rupee declined just 1.2 percent between January and November 2024, but fell an equivalent amount within five days from February 1 to February 5, 2025, highlighting growing pressure.
• A narrowing interest rate differential makes rupee assets less attractive, potentially accelerating capital outflows and speculative selling.

While some economists argue that foreign investors are primarily drawn to Indian equities rather than interest rate differentials, a weaker currency could deter inflows and increase external vulnerabilities.

Liquidity and Regulatory Measures

With the global trade environment facing uncertainty, it remains unclear whether the worst of the rupee’s decline is over.

• Providing excessively dovish liquidity assurances could aggravate the rupee’s weakness and lead to further capital outflows.
• Inflation risks persist, particularly in food prices, which could escalate due to higher consumer spending following recent budgetary tax reliefs.

Markets are also focused on whether the April 2025 deadline for new Liquidity Coverage Ratio (LCR) rules will stand. These regulations require banks to increase holdings of government securities to mitigate risks from unstable short-term deposits.

Additionally, the RBI’s proposed Expected Credit Loss (ECL) provisioning norms and revised risk weights for project finance could increase capital requirements for banks.

• Delaying the implementation of these rules could provide short-term relief to lenders.
• Structural reforms should be implemented in stable market conditions rather than during periods of heightened currency volatility.

A Measured Approach is Essential

Likely RBI Actions:

• A repo rate cut is highly probable.
• The CRR may be reduced, or additional liquidity measures may be introduced.
• The LCR, ECL, and project finance rules will likely be deferred.

What the RBI Should Avoid:

• Excessive liquidity assurances, which could exacerbate rupee depreciation.
• Easing risk weights on bank loans, as this could increase financial sector vulnerabilities.

While monetary easing is justified, a complete policy shift would be premature. The RBI must carefully balance growth support with currency stability, ensuring that monetary policy remains effective amid evolving global and domestic challenges.