Focussing on the spirit of the 'flexible' inflation target framework

RBI cuts rates for first time in nearly 5 years: Full text of Governor Sanjay Malhotra's speech

Sakshi Gupta, Principal Economist, Treasury Group, HDFC Bank

The RBI’s decision to cut the repo rate by 25bps aligns with the flexibility embedded in the inflation target framework. The central bank chose to tilt towards supporting growth as the path towards 4 percent inflation becomes visible. While the rate cut is the highlight of today’s decision, the announcement also offers a glimpse into the thinking and intent of the RBI under the new governor.

The change in guard at the RBI brings with it a new approach. Three aspects stand out.

Over the last few months, the MPC had erred on the side of caution keeping the policy rate unchanged, highlighting the risks from inflation to economic growth and the centrality of hitting the 4% inflation target for policy decisions. Instead, the decision to cut the policy rate today has relied on utilising the space provided by the inflation target band of 4+/- 2%. While inflation for December stood at 5.2%, the RBI has taken comfort in the fact that inflation is expected to move towards 4% over the coming months. Admittedly, this has also been enabled by visible trends of disinflation in food prices, healthy progress of the winter crop and recent softness in oil prices.

The RBI pegs inflation at 4.2 percent in 2025-26, coming down from 4.8 percent this year – which seems achievable. The confidence on the inflation front was further buttressed by the governor’s comments on the positive trends not just in retail but also wholesale inflation – last at 2.37 percent in December. The RBI remains optimistic on growth expecting it to climb to 6.7% in 2025-26 – which lies at the higher end of the 6.3-6.8 percent range laid out in the economic survey. While achievable, it assumes that everything – from consumption to investments -- falls perfectly in place.

Beyond the growth-inflation trade-offs, the RBI also spelt out a more balanced approach towards regulations. An approach that recognises not just the benefits but also “the costs” associated with regulatory changes. The central banks’ intent is for a consultative process taking stakeholders on board while also providing ample transition times for any new regulation. The long overdue clarification on some of the proposed regulatory changes including the LCR norms, ECL and Project financing framework not being implemented at least till March 2026 is a much-needed and welcome step in this regard.

Another aspect that drew considerable attention to the policy is the movement of the rupee. After a period of considerable stability, the rupee depreciated by almost 3.7 percent over the last three months. The incessant rise in the US dollar given the risks of tariffs has driven this move. However, the RBI’s tolerance towards this level of volatility has taken markets by surprise. In the policy statement, the governor clarified that while smoothening “excessive” moves in the rupee is important, this should not come at the cost of market efficiencies and therefore the level of the rupee is a function of market forces. The implication is, bto e prepared for a more volatile rupee that aligns with the movement in our peers.

That said, extreme rupee depreciation can have adverse effects on growth, consumer confidence and investment decisions. This seemed to be the biggest concern for the RBI, more so than imported inflation. Going forward, what levels or pace of rupee depreciation would be the line in the sand for the RBI remains to be seen.

Moreover, what would be interesting to see is if the governor’s intent of a freer hand on the rupee would also hold during periods of capital inflows. Or would he lean towards shoring up reserves – like his predecessor – and save for a rainy day? After all, the record build-up in foreign exchange reserves (crossed $700 billion in September 2024) is what has enabled India’s relative resilience in weathering the Trump shock. If demand and supply forces are allowed to play out both in depreciation and

appreciation episodes, exporters need to prepare for any future reversals as well. To recall, during Trump 1.0, after an initial period of weakness, the rupee went on to appreciate by 6 percent during 2016.

If weather conditions and global headwinds reignite inflationary risks or capital flows/rupee, the rate-cut cycle could be short and shallow.

The RBI also has its task cut out in terms of liquidity management. This is critical to the transmission of rate cuts and ensuring ample credit flow to boost growth. While the central bank committed to providing sufficient liquidity, it refrained from announcing any new measures. Given the liquidity pressures ahead – both from continued foreign outflows and frictional drags that become stronger during year-end, the need for greater durable liquidity infusion is expected to rise.

For now, the RBI policy has successfully followed the budget with a mini booster for the economy. Hopefully, this will help us get to a 6.5+ percent growth next year.

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