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Informist, Thursday, Feb. 27, 2025

MUMBAI –  With India's inflation likely to converge to target and a largely closed supply gap, room should arise for gradual policy rate cuts by the Reserve Bank of India's Monetary Policy Committee, with timing and pace remaining data dependent, the International Monetary Fund said in a report on Thursday.

"Directors welcomed the Reserve Bank of India's well-calibrated monetary policy with inflation remaining within the target band. They noted that opportunities could arise to gradually lower the policy rate further, and stressed that monetary policy should remain data-dependent and well communicated," the IMF said in a press release.

While the IMF expects inflation to align itself to the Monetary Policy Committee's target of 4% gradually, India's real GDP is expected to grow at 6.5% in the current financial year and the next one as well. "Real GDP is expected to grow at 6.5% in 2024-25 and 2025-26, supported by robust growth in private consumption on the back of sustained macroeconomic and financial stability," it said.

India's GDP data for Oct-Dec along with the second advance estimate for the current financial year ending March is due Friday. According to a poll of 16 economists by Informist, GDP growth is expected to have risen to 6.3% in the final quarter of 2024. As per latest data, the first advance estimate of GDP growth in FY25 is 6.4%, the lowest in four years. The provisional estimate of FY24 growth is 8.2%, while the first revised estimate for FY23 growth is 7.0%.

The report also said that India's monetary policy has remained prudent with the real interest rate remaining above the estimated neutral rate. The IMF staff assumes a real neutral rate of 1.6%. 

India's inflation targeting framework has proven effective in managing inflation and anchoring inflation expectations, the report said. The RBI has a mandate to keep inflation within the target of 4%, with a tolerance band of +/- 2 percentage points for the Monetary Policy Committee. However, if inflation declines faster than anticipated, coupled with weaker-than-expected growth outcomes, faster monetary easing would be warranted, the report said.

Due to the risk of spillovers from headline inflation to household inflation expectations, it remains an appropriate target. The ease of monetary policy communication and the high weightage of food inflation in the CPI basket also make the flexible inflation targeting suitable for India, the report said. "The RBI's transparent communications regarding the monetary policy stance have continued to guide market expectations," the report said.

The RBI should also remain nimble to evolving conditions while managing liquidity and should continue to prioritise market based tools, the report said.

The RBI's intervention in the foreign exchange market should be limited to addressing disorderly market conditions as greater exchange rate flexibility is warranted to help absorb external shocks, the report said. "Given India's relatively low foreign exchange mismatch, well-anchored inflation expectations, and a generally deep FX market, the FIT (flexible inflation targeting) framework should be supported by greater exchange rate flexibility, allowing the currency to adjust in response to external shocks while maintaining domestic price stability," the report said.

However, the report highlighted the supporting role of foreign exchange intervention during periods of global financial stress which leads to destabilisation in the dollar/rupee premiums. Timely interventions can play a supporting role to improve market functioning and mitigate adverse impacts of sudden currency movements on output and inflation, the report said.

More flexibility in the exchange rate would also reduce the need for holding costly foreign exchange reserves, the report said. The IMF projects India's foreign exchange reserves to be at $674 billion at the end of FY26. Better flexibility in the exchange rate would also promote development of the market, prevent moral hazard by encouraging companies to actively manage their currency risk through hedging, and reduce fluctuations in domestic financial system liquidity, the report said.

The report also commented on the progress of India's central bank digital currency or e-rupee. At the end of 2024 the e-rupee had 5 million users with 500,000 merchants and 16 banks in the retail pilot. "The authorities continue to develop programmability and offline usage, with several test cases in progress. Cross-border payment applications are being explored through both bilateral and multilateral channels, but broadly remain in the nascent stage," the report said. The wholesale e-rupee has had limited usage, though some applications in financial markets are being considered, it said.

India's monetary policy should be prepared to support the economy in case of a global growth slowdown, which the IMF sees as a risk. More importantly, policy should be able to support the economy in case of escalation or spread of the conflict in Gaza and Israel, Russia's war in Ukraine, and if other regional conflicts or terrorism disrupt trade.

However, if stronger private consumption and investment, and increasing consumer confidence contributes to higher potential growth, a faster consolidation and a tighter monetary policy could be warranted, the report said.  End

Reported by Kabir Sharma

Edited by Ashish Shirke

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