Secrets Behind RBI's Economic Stimulus Strategy!

The Reserve Bank of India's (RBI) recent decision to implement significant rate cuts has puzzled many economists. Despite indicators showing a stable economy, the RBI reduced the repo rate by 50 basis points and the cash reserve ratio by 100 basis points on June 6. This move, which shifted the monetary policy stance from "accommodative" to "neutral," suggests future rate changes could go either way.

Following these unexpected cuts, Indian bond yields initially rose by about 10 basis points before slightly decreasing in subsequent weeks. This reaction highlights the confusion among investors regarding the RBI's actions. The economy appears to be on a steady path, with several high-frequency indicators pointing towards stability and growth.

Economic Indicators and Inflation

Goods and services tax collections, reflecting corporate revenue, have been rising steadily since late 2024. Similarly, E-Way bills, which indicate goods movement and tax compliance, have increased by over 13% year-on-year in the past year. These trends suggest an improving economic trajectory for India.

Inflation also seems manageable, with food inflation expected to decline due to forecasts of a normal monsoon season boosting food production. Lower food prices could support urban consumption and ease growth concerns further.

Reasons Behind Rate Cuts

Despite these positive signs, RBI Governor Sanjay Malhotra explained that growth was below expectations amid global uncertainty. This prompted the Monetary Policy Committee to ease policy to stimulate consumption and investment growth. However, global uncertainty is only part of the story.

There are indications that Indian consumption might face challenges. Passenger car sales remain subdued with less than 2% year-on-year growth in the fiscal year ending March 2025. In contrast, motorcycle and scooter sales grew by 9.1%, indicating stronger rural and semi-urban consumption.

Household Debt Concerns

A more concerning trend is households financing consumption through increased debt. Household debt as a percentage of GDP has risen from 36% to 42% over two years. Credit card loans have surged by 50% over three years, while household savings rates have dropped from 24% a decade ago to about 18% now.

The RBI's rate cuts aim to lower borrowing costs for mortgages and personal loans, potentially easing household financial stress. This could increase disposable incomes and boost consumption and investment in theory.

Challenges Ahead

However, merely making money cheaper may not suffice to boost consumption significantly. Confidence in job security and income visibility is crucial for increasing spending. Central banks typically keep some "dry powder" or room for more stimulus as a precaution against ineffective monetary policy moves.

The RBI still has some room for maneuvering but not as much as ideal. The lowest repo rate in the past decade was during the pandemic at 4%, which is 1.5 percentage points below its current level. Excluding the pandemic period, it has usually been only about 50 basis points lower than now.

Future Prospects

The cash reserve ratio is already at a record low, limiting monetary space further if more stimulus is needed. Governor Malhotra suggested that more policy space could open if inflation falls below projections. Fortunately for the RBI, consumer inflation seems headed that way.

Since February, CPI inflation has remained below the RBI target of 4%. With May's print at 2.82%, inflation might reach a decade low soon due partly to moderating food prices and increased imports from China amid its deflation struggles.

The Israel-Iran conflict initially threatened an oil price spike but now seems less likely after a ceasefire announcement. However, ongoing trade tensions could pressure global prices while affecting growth negatively.

The RBI's substantial rate cuts aim to maintain India's economic momentum but could limit future stimulus options when necessary most.