Reserve Bank of India surprisingly cuts key interest rate

The Indian central bank surprisingly cut its key interest rate today. Just after six months of hiking its main repo rate, the Reserve Bank of India cut the interest rate by 25 basis points to 6.25 percent. The consensus expectations was for the main repo rate to remain unchanged at 6.5 percent. This marks a sharp reversal of monetary policy from “calibrated tightening” to neutral. The RBI cut the reversal repo rate by 25 basis points to 6 percent, whereas the cash reserve ratio was kept unchanged at 4 percent.

Immediately after the news, the Indian rupee had depreciated 0.2 percent against the USD. However, the INR has quickly reversed its loss. The rate cut shows that the central bank’s concerns have moved from inflation to growth. The headline inflation has eased steadily from close to 5 percent in June 2018 to 2.2 percent in December 2018, mainly owing to falling prices of food. Meanwhile, growth momentum is weakening. More recent data, such as exports, imports, industrial production, and car sales have deteriorated.

Even if the rate cut is welcome from a growth perspective, it bears the risk of undermining the central bank’s credibility. It was the first central bank meeting after former RBI governor Urjit Patel exited suddenly in December, amidst heated confrontation with the government over how to handle the struggling banking sector.

The sharp policy reversal raises the question about whether the central bank’s inflation target is well-anchored. The current headline inflation has undershot the medium-term inflation target of 4 percent. However, it happened against the backdrop of a decline in food prices, which are very volatile. A reversal of food prices would rapidly stoke up inflation again. The core inflation continues to be elevated above 5 percent. If the RBI constantly bases the rate decisions on food prices, its inflation target would become less trustworthy, noted Nordea Bank in a research report.