RBI’s Monetary Policy and Economic Growth Prospects

Economists widely predict that the Reserve Bank of India’s (RBI) recent liquidity measures will enable the Monetary Policy Committee (MPC) to implement a shallow rate cut. This anticipated decision follows the Government of India’s consumption-led growth strategy outlined in the FY26 Budget. With retail inflation easing and GDP growth slowing, the RBI faces pressure to stimulate the economy through adjustments in the repo rate.

Recent Economic Context

• The MPC has maintained the repo rate at 6.50% since it was last raised nearly two years ago.
• This decision aimed to align with a 4% inflation target.
• However, with inflation decreasing to 5.22% in December 2024 and GDP growth dropping to 5.4%, the need for a rate cut has become more pressing.
• The RBI’s goal is to support economic recovery while managing inflation.

Liquidity Measures by RBI

• To prepare for a potential rate cut, the RBI has introduced several liquidity measures. These include a 25 basis points cut in the cash reserve ratio and various open market operations.
• Notably, the RBI recently announced liquidity injections totalling ₹60,000 crore and a USD/INR swap auction worth $5 billion.
• These actions are designed to enhance liquidity and improve policy transmission.

Impact of Currency Depreciation

The depreciating Indian rupee poses a challenge for the RBI. Since Donald Trump’s election, the rupee has weakened against the dollar, which could lead to increased import costs and inflation. This situation complicates the decision-making process for the MPC regarding rate cuts. The RBI must balance the need for growth with the risks associated with currency depreciation.

Expectations for Rate Cuts

• Economists anticipate a 25 basis points rate cut in the upcoming February meeting, followed by another cut in April.
• This gradual approach aims to stimulate growth without impacting inflation.
• Experts suggest that these cuts, combined with ongoing liquidity measures, are crucial for supporting economic activity in 2025.

Role of Monetary Policy in Growth

• The RBI’s monetary policy will play a critical role in encouraging economic growth amidst fiscal consolidation.
• As inflation stabilises, the RBI is expected to adopt a more growth-supportive stance.
• Economists argue that timely rate cuts will minimise the risk of economic stagnation and support the government’s broader economic objectives.

Future Economic Outlook

Looking ahead, the RBI’s actions will be very important in shaping India’s economic landscape. The success of these monetary measures will depend on various factors, including global economic conditions and domestic demand. The interplay between fiscal policy and monetary policy will be essential for achieving sustainable growth.

Questions for UPSC:

1. Critically analyse the impact of liquidity measures on India’s economic recovery post-Budget FY26.
2. What is the significance of the repo rate in controlling inflation? How does it affect economic growth?
3. Estimate the potential risks associated with a depreciating rupee for India’s economy.
4. With suitable examples, discuss the role of monetary policy in managing inflation and growth in developing economies.

Answer Hints:

1. Critically analyse the impact of liquidity measures on India’s economic recovery post-Budget FY26.

1. Liquidity measures such as cash reserve ratio cuts and open market operations enhance money supply in the economy.
2. Increased liquidity can stimulate consumption and investment, crucial for economic recovery.
3. The RBI’s ₹60,000 crore liquidity injection aims to support sectors affected by the Budget’s consumption-led approach.
4. Effective policy transmission is necessary for these measures to translate into real economic growth.
5. Potential challenges include ensuring that liquidity does not lead to inflationary pressures while encouraging growth.

2. What is the significance of the repo rate in controlling inflation? How does it affect economic growth?

1. The repo rate is the rate at which the RBI lends to commercial banks, influencing interest rates across the economy.
2. A higher repo rate typically curbs inflation by making borrowing costlier, reducing spending and investment.
3. Conversely, a lower repo rate encourages borrowing and spending, which can stimulate economic growth.
4. Maintaining a balance is crucial; excessive rate cuts may lead to inflation, while high rates can stifle growth.
5. The repo rate thus serves as a key tool for the RBI to achieve its inflation and growth targets simultaneously.

3. Estimate the potential risks associated with a depreciating rupee for India’s economy.

1. A depreciating rupee increases the cost of imports, especially crude oil, which can stoke inflation.
2. Higher import costs can lead to a trade deficit, impacting the overall economic stability.
3. It may deter foreign investment as currency volatility raises risks for investors.
4. Consumer purchasing power declines, leading to reduced domestic demand and slower economic growth.
5. Persistent depreciation may necessitate tighter monetary policy, complicating growth efforts.

4. With suitable examples, discuss the role of monetary policy in managing inflation and growth in developing economies.

1. Monetary policy in developing economies often targets inflation control while promoting growth, balancing both objectives.
2. For example, India uses repo rate adjustments to manage inflation while encouraging economic growth through lower rates.
3. In Brazil, the central bank’s rate cuts during economic downturns aimed to boost growth while managing inflation expectations.
4. Effective communication of policy changes helps anchor inflation expectations, as seen in South Africa’s monetary policy framework.
5. Overall, adaptive monetary policy is crucial for responding to economic shocks and ensuring sustainable growth in developing economies.