Managing inflation gets precedence over growth

It is clear that price stability and liquidity management get precedence over economic growth in the MPC resolution of December 06, 2024, and attendant statements from the RBI. Even though real growth measured in terms of GDP at constant prices has substantially slowed down in Q2 of 2024-25 to 5.4 as against 8.1 percent in Q2 of 2023-24, the MPC has refrained from a policy repo rate cut with a 4:2 voting by the members. In the words of the RBI Governor: “… only with durable price stability can a strong foundation be secured for high growth.”

Price stability is essential for sustained growth, and if growth slowdown lingers beyond a point, it may need policy support

MPC has revised the real growth rate downwards and the CPI–combined growth rate upwards in its December 06, 2024 position as compared with the October 09, 2024 resolution (Table 1). 

Table1 (in percent)

The slowdown in real growth in Q2 to 5.4 percent and CPI combined inflation rate increased to 6.2 per cent in October 2024 (which was highest since 2023) have been termed as an “aberration” by the Governor. To prove this point, as set out in table 1, the growth rate has been projected higher as 7.3 per cent and inflation rate has been reduced to 4.0 percent in the Q2 of 2025-26.

Given that two members have voted for a rate cut, forward guidance on the policy repo rate cut would have been appropriate at this time. This is missing

Given the potential uncertainty arising out of the subdued performance of the manufacturing sector, the slowdown in urban demand coupled with weak investment sentiments, there are doubts about the optimistic growth forecast. Geopolitical tension and geo-economic fragmentation could be a potential threat to commodity prices and a potential threat to continuing fuel group deflation for the 14^th consecutive month till October 2024. In addition, the clarity on monsoon and climate change have not been unfolded. Therefore, there is a big question mark in bringing down the inflation rate forecast to the average of 4 per cent in Q2 as mandated in flexible inflation targeting (FIT). 

As alluded to earlier, when price stability is the priority and the RBI is focused on controlling inflation and anchoring inflation expectations, the economy must then see a “disinflation glide path” which would come at the cost of growth. However, in marked contrast to this, the inflation and growth estimates have not explicitly recognised this. Estimates show inflation as coming down from 4.6 in Q1 to 4.0 percent in Q2 of 2025-26, and growth as going up to 7.3 percent from 6.1 percent in the same period. How will this work? The projection is inherently contradictory.

While reduction in CRR is a welcome move, encouraging capital flows through debt instruments like NRI deposits is a matter of concern 

The debate on policy repo rate cut and inflation management in the MPC resolution is not new. Both the old and new MPC members have been differing with the monetary stance and policy repo rate cut. Since the October 2024 MPC resolution, the stance has been neutral to provide “flexibility to monitor the progress and outlook on disinflation and growth and to act appropriately”. However, the MPC has kept the policy repo rate unchanged at 6.5 percent for the past 12 MPC cycles or past 24 months. 

The October 24 print of higher inflation (6.2 percent) accompanied by slowdown of growth to 5.4 percent in the Q2 of 2024-25 have raised doubts that whether India is facing a “stagflation”. However, such a view is erroneous, given that it is based on limited data point, of Oct 2024 inflation rate and Q2 real growth rate. 

The RBI is concerned about tightening of rupee liquidity and dollar liquidity but is somewhat comfortable with the growth trajectory

In the above context, it is important to flag the Governor’s remark that price stability is essential for sustained growth, and if growth slowdown lingers beyond a point, it may need policy support. The Governor has also emphasised the criticality of the timing of a decision. However, given that two members have voted for a rate cut, forward guidance on the policy repo rate cut would have been appropriate at this time. This is missing.

Now let us turn to liquidity management by RBI and the decision on cash reserve ratio (CRR) and raising interest rate on Foreign Currency Non-Resident Bank [FCNR(B)] deposits. As a part of the statement on developmental and regulatory policy, particularly relating to liquidity, the RBI Governor has announced a reduction in Cash Reserve Ratio in by 50 basis point in two equal tranches of 25 basis points with effect from the fortnight beginning December 14, 2024 and December 28, 2024 respectively. This will restore CRR to 4 per cent and would release primary liquidity of about Rs. 1.16 lakh crore to the banking system. 

Geopolitical tension and geo-economic fragmentation could be a potential threat to commodity prices

The second announcement related to FCNR(B) deposits where the interest rates has been raised for maturity of one year to less than three years (Overnight Alternative Reference Rate or ARR plus 400 basis points as against ARR plus 250 basis points currently) and for maturity three to five years (ARR plus 500 basis points as against ARR plus 300 basis points currently). This is a temporary measure available till March 21, 2025.

These two measures have been taken by the RBI to manage the potential adverse impact of tightening system liquidity in the coming months due to tax outflows, increase in currency circulation, and volatility in capital flows. As per the data available in the Weekly Statistical Supplement (WSS), forex reserves declined by US $17.76 billion during the week ended November 15, 2024. This implies that the RBI has sold these dollars to address the volatility in the foreign exchange market as the rupee depreciated against the dollar due to capital outflows. 

While the reduction in CRR is a welcome move, encouraging capital flows through debt instruments like NRI deposits is a matter of concern as external debt will increase, as also the interest payment on external debt. As on June 2024, for which the latest data is available, the outstanding NRI deposits stood at US $194.1 billion, accounting for 28.4 percent of total external debt. Further, an increase in NRI deposits as a debt instrument is a burden as it will be repaid from the forex reserves.

To conclude, the RBI is not quite sure about the movement of inflation. In addition, the RBI is concerned about tightening of rupee liquidity and dollar liquidity but is somewhat comfortable with the growth trajectory. Therefore, in the December 2024 monetary policy statement, managing inflation and liquidity management gets precedence over growth.