RBI’s policy review: Why this time is truly different

Let us first look at the arguments that favour a rate cut. RBI made it clear in its last policy statement that a change in its stance to ‘accommodative’ is an indication of future rate cuts. Hence, the debate on whether such a stance meant there would be more liquidity rather than rate action is not relevant.

Also Read: Mint Quick Edit | An inflation dip enlarges RBI’s policy space 

Indeed, RBI has been supplying liquidity on a daily basis through overnight variable repo rate (VRR) auctions. So the tap has been kept open. This has been supplemented with aggressive open market operations (OMOs) in April and May. Around ₹2 trillion of funds have been provided through RBI purchases of government paper from banks. Hence, RBI has ensured that a precondition to rate cuts—surplus liquidity—has been met.

Separately, inflation has come down to 3.2%. This was not unexpected, as the high base of last year and April’s decline in food prices, especially of vegetables, supported this downward movement. Also, for the next two months, the inflation rate is expected to remain under 4%. The quarterly inflation rate may turn out lower than the RBI forecast of 3.6%. 

Further, RBI expects inflation to be 3.9% and 3.8% in the subsequent two quarters. All this means that inflation will not be a challenge. Add to this the fact that the India Meteorological Department has forecast a normal monsoon, implying food inflation is unlikely to be a concern.

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The fall in inflation to 3.2% has led to a rather irrational reaction from markets as well as analysts. Bond yields have come down sharply. Further, expectations of the number of rate cuts have gone up to three or four of 25 basis points each from the two that were expected before April’s inflation number was announced. This has been accompanied by a stronger pitch for rate cuts by analysts, industrialists and academics. In economics, such expressions could become self-fulfilling.

The rate-cut argument is also supported by the weak-growth hypothesis, the rhetoric around which bears mixed messages. Growth at 6.5% for 2025-26 is highlighted as being the world’s highest for a major economy. But it is also argued that growth is low and needs monetary policy support.

The arguments for a rate status quo are also quite compelling.

The first is monsoon rains. While good rainfall is expected, we need to watch how the monsoon behaves in June and July. Often, more important than all-India data is the spread of rainfall across regions. In the past, a normal monsoon for the country has had sub-normal conditions in the interiors, resulting in output shocks—for pulses and oilseeds in particular. This can be inflationary. We’ll get a better picture only by end-July.

Also Read: More than a rate cut: RBI’s decision reinforces its dual mandate

Second, the US will decide on tariffs in early July. While it looks like they will be less severe than what were announced in April, the fact that they might be higher than the US threshold of 10% means that commodity prices will increase. The exact impact will be known once the tariff scales are finalized.

Third, under these conditions, it can be argued that when there is a slack in demand for credit, there should be no hurry to cut rates. These can be deferred to August if all looks good. There would be no loss for the economy.

Fourth, as an extension of this argument, there is the question of the banking system’s absorptive capacity. There have been two rate cuts already and banks have started passing them on, albeit in a limited manner. While external benchmark lending rate (EBLR) loans get repriced immediately, deposit repricing takes time as these rates have to be changed by banks.

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Presently, the stock market is doing rather well and is a viable option for households to park funds. Last year saw a migration from bank deposits to capital markets, with investments attracted by better returns. This is why banks have been changing deposit rates selectively for specific tenures. A deferred rate cut would mean less pressure on banks.

Hence, there are strong arguments on both sides. The broader question is whether rate cuts will translate to a pick-up in credit and in turn lead to higher investment and economic growth. This is important because during covid, the repo rate came down to 4%, but did not quite excite investment. That’s because demand matters. The benefit of cheaper credit will go to home buyers and small and medium enterprises that borrow at EBLR-linked rates. But business investment in general is a function of market demand, buoyancy in which is still largely confined to the premium end.

India’s economy is moving along a rather unique path. We need higher consumption and savings both. Consumption is needed to spur investment, but savings are required to support lending. Normally, a fast-growing economy can support both. But with growth at the present plateau level of 6.5% or so, higher consumption would come at the cost of savings, which may not be a bad thing.

Lowering interest rates in June, however, could distort the pricing of capital. This is something that requires deeper thought.

These are the author’s personal views.

The author is chief economist, Bank of Baroda, and author of ‘Corporate Quirks: The Darker Side of the Sun’.