Food or the Fed – what will drive the RBI’s monetary policy?

Relevance: GS Paper III

Why in News?

The Reserve Bank of India (RBI) has a complex decision-making process in formulating its monetary policy, which is influenced by both domestic and international factors. 

Domestic Factors Influencing RBI's Monetary Policy

1. Current Inflation Trends:

• Headline Inflation: Although India's consumer price index (CPI) stood at 4.83% in April, food inflation was significantly higher at 8.7%. This discrepancy indicates that while overall inflation appears to be moderating, food prices remain a concern.
• Core Inflation: At a multi-year low of 3.2%, core inflation, which excludes food and fuel, suggests underlying demand pressures in the economy are weak. This could be indicative of sluggish economic activity.

2. Forecasted Inflation:

• The RBI expects inflation to average 4.5% in the fourth quarter of 2024-25. This relatively benign forecast suggests that the central bank sees inflationary pressures easing over time, provided food prices stabilize.

3. Economic Growth:

• Low core inflation points to weak demand, which can be a sign of slowing economic growth. In such a scenario, the RBI might consider rate cuts to stimulate economic activity.

4. Monsoon and Food Prices:

• The trajectory of food prices heavily depends on the monsoon. An above-normal, evenly distributed monsoon could alleviate food inflation, supporting the case for easing monetary policy.

International Factors Influencing RBI's Monetary Policy

1. US Federal Reserve Policy:

• The US Fed's stance on maintaining higher interest rates for longer periods can influence global capital flows and currency stability. If the Fed holds rates steady or delays cuts, it can pressure the RBI to maintain higher rates to prevent capital outflows and rupee depreciation.
• The RBI's unscheduled rate hike in May 2022 was likely influenced by the Fed's policy actions. This historical context underscores the RBI's sensitivity to Fed decisions to maintain interest rate differentials and stabilize the rupee.

2. European Central Bank (ECB) and Bank of England (BoE) Policies:

• Divergent policies between the ECB, BoE, and the Fed indicate a more complex global environment. While the ECB and BoE may cut rates due to their domestic conditions, the RBI must weigh these actions against the potential impact on the rupee and India's financial stability.

Balancing Domestic and International Considerations:

• Real Interest Rates: External member of the Monetary Policy Committee of the RBI Jayanth Varma's view that a lower real rate could help align inflation with targets highlights a potential path for rate cuts. Given the forecasted inflation of 4.5%, maintaining the repo rate at 6.5% implies a real rate of around 2%, which might be seen as sufficiently tight to control inflation without stifling growth.
• Currency Stability: Maintaining an interest rate differential with major economies like the US can be crucial for the RBI to prevent the rupee from depreciating sharply, which could exacerbate inflation through higher import costs.

The Decision-Making Dilemma

1. If Domestic Conditions Prevail:

• If the monsoon is favourable and food prices stabilize, the RBI might prioritize domestic economic growth, leading to a gradual reduction in rates.
• A lower real rate could support economic activity, especially if core inflation remains low, indicating weak demand.

2. If International Factors Dominate:

• Should the Fed maintain a tight policy, the RBI might be cautious in cutting rates to avoid capital outflows and a depreciating rupee.
• Even if domestic conditions favour a rate cut, the international environment might compel the RBI to maintain higher rates to safeguard financial stability.

Conclusion:

The RBI's monetary policy will likely be a balancing act between responding to domestic growth-inflation dynamics and adjusting to the international policy cycle, particularly the actions of the US Federal Reserve. The central bank will need to carefully monitor domestic inflation trends, especially food prices, and the monsoon's impact while being cognizant of global interest rate movements to ensure a stable economic and financial environment.