From the Opinions Editor: On interest rates, is RBI joining the right dots?

First, is there space for cutting interest rates further? Are the central bank’s forecasts accurately gauging the price pressures in the economy? Second, to what extent should the fiscal impetus to private consumption – operationalised via cuts in personal income taxes and GST rates – be complemented with further monetary policy support? Third, is the Indian economy growing at its potential growth rate? What are the central bank’s views? The answers to these questions should determine the path of interest rates – though, in the past, other considerations, such as defending the currency, have dominated.

Let’s begin with prices. As per the RBI’s baseline projections, inflation is expected to edge upwards from 2.6 per cent in 2025-26 to 4.5 per cent in 2026-27. Considering that the repo rate stands at 5.5 per cent, on a forward-looking basis, this broadly translates to a real interest rate of 1 per cent. This suggests that there is no space to cut rates. But the question is whether the central bank is overestimating the price pressures in the economy? This wouldn’t be the first time that it would be doing so.

In October last year, the monetary policy committee had voted to keep the benchmark repo rate at 6.5 per cent. Retail inflation had risen to 5.5 per cent in September, and further to 6.2 per cent in October, above the upper threshold of the central bank’s inflation targeting framework. The RBI had then forecasted inflation at 4.3 per cent in the first quarter of 2025-26, with full-year inflation at 4.1 per cent. This implied a real interest rate of slightly more than 2 per cent. Surely, such a tight policy was needed to bring inflation in line with the target. Wrong.

Headline inflation was then driven by high food inflation. But many did expect food prices to soften. In fact, the RBI also seemed to share that view, but strangely chose not to look through the spurt in vegetable prices, even though what matters for monetary policy is not inflation now, but a few quarters down the line. The view that high food prices were “transient” was validated with the food inflation falling from 10.87 per cent in October 2024 into a deflationary zone at -2.28 per cent in September 2025. Moreover, core inflation, which is a better indicator of underlying price pressures in the economy, was at just 3.2 per cent in September last year, indicating the absence of any price pressures in the broader economy. (Core inflation excludes food, fuel, gold and silver).

This meant that the central bank was then overestimating the price pressures. Inflation in the first quarter of 2025-26 was not 4.3 per cent but 2.7 per cent. The RBI has cut its inflation forecast for the year from 4.2 per cent in February to 3.1 per cent in August and then to 2.6 per cent in October, implying that the real interest rate in October 2024 was not around 2 per cent, but considerably higher. Policy was excessively tight. Other considerations, not inflation, then dominated the central bank’s interest rate policy.

All this suggests the possibility that the central bank is not accurately gauging the price pressures in the economy. While the headline inflation number may well edge upwards next year, it is more likely to be on account of the base effect, not growing price pressures. Core inflation (excluding food, fuel, gold, and silver) continues to remain flat at 3.2 per cent in September, signalling weak demand, and the space to grow faster without increasing inflation. Moreover, the full impact of the GST rate cuts will probably reflect from the October data onwards. And with China exporting its surplus capacity, it will only exert downward pressure on prices. All these points point towards the space to cut rates further.

Then there is the issue of the recent tax cuts. While the GST cuts do appear to have boosted demand during the festive season — credit growth has picked up — the question is whether this uptick — more in consumer durables, and more in the high-end category — will sustain or taper off? While this would be known only in the weeks and months ahead, with demand exceeding expectations, production is also likely to have picked up as firms will look to rebuild their depleted inventories.

However, only a sustained increase in capacity utilisation rates will trigger another round of investments. But, the difference between the RBI’s June/August and October growth projections for the second half of this year (October-March) — the latter would have factored in the effects of Trump’s tariffs and the GST cuts — suggests that the negative impact of the former outweighs the positive impulse of the latter. The growth momentum is not that strong. At this time, lowering the cost of borrowing further should help stimulate both consumption and investment demand. This brings us to the issue of the economy’s growth potential.

This year, the RBI expects the economy to grow at 6.8 per cent, marginally higher than the 6.5 per cent last year. This growth is now being seen as being “below our aspirations”, even though the RBI has not clearly spelt out its estimate of potential GDP or the output gap. But, if that is indeed the case, and the economy is operating below the aspirational growth, or in other words, below its potential growth, then not only is the current policy stance wrong – the stance should be accommodative, not neutral, as that “neither calls for stimulating economy activity nor for controlling inflation” – but also lower rates are called for. If the MPC does not change its stance and lower rates, then the economy, at least as per RBI, is operating at its potential growth. That would be another odd decision. Real GDP appears high because of the issue with the deflators. There is slack in the economy.

Fiscal and monetary measures are, however, unlikely to be enough. Sustained high growth requires reforms.

Till next time,
Ishan Bakshi