Monetary policy: Is the status quo justified?

The RBI decided to maintain the policy rate at 6.5 per cent in its Monetary Policy Statement of August 2024.

The growth forecast for FY 24-25 remains 7.2 per cent. The inflation forecast remains 4.5 per cent. What is the case for cutting the policy rate and for not cutting the rate?

i. The case for cutting the policy rate

• With inflation projected at 4.5 per cent, the real rate is 2 per cent. This is too high. A real rate of 1.0 per cent is the "neutral rate", that is, where inflation is stable and growth is maximised. So, there is adequate scope for cutting the policy rate. The problem is that the RBI's estimate of the neutral rate has changed. In FY 22, the neutral rate was estimated at 08-1 per cent. More recently, it estimates the neutral rate at 1.4-1.9 per cent. If you accept the upper end as the estimate, the present neutral rate of 2 per cent seems okay

ii. The case against cutting the policy rate:

• The neutral rate argument apart, the RBI governor has said repeatedly that the RBI wishes to move the inflation rate down to 4 per cent. Food inflation remains elevated. Cutting the policy rate at this point would thus not serve the objective of meeting the inflation target of 4 per cent.
• India's growth rate of 7.2 per cent is pretty impressive in what is the bleakest world economic environment in the past two decades. Even if growth falls to 7 per cent, that would be good enough. It is incorrect to suppose that cutting the policy rate can enhance the growth rate. Why risk higher inflation when the growth rate does not have much chance of accelerating?
• The rupee is pushing close to Rs 84 to the dollar. A cut in the rate would make it difficult for the RBI to contain the rupee below Rs 84, beyond which it does not wish to see the rupee depreciate. The stance could change if the Fed and European banks cut their rates down the road. But a rate cut at this point would be imprudent in relation to maintain stability in the rupee exchange rate.

I would add one more point to the case against cutting the policy rate: geopolitical tensions. There has been an escalation in the situation in both Ukraine and Gaza. Neither conflict has thus far affected the global economy significantly. But we don't quite know when "managed escalation"- the game that NATO and Russia and Israel and Iran and its proxies have been playing- will get out of hand. 

As I write, Israel is bracing for a massive retalisation from Iran and its Lebanese ally, Hezbollah. If a regional war breaks out, oil prices could shoot up and render all macroeconomic estimates meaningless. Better to err on the side of caution in these troubled times- especially when gdp growth is over 7 per cent.