Most of the world’s leading central banks like the Federal Reserve (Fed), European Central Bank (ECB), Reserve Bank of India (RBI) and Bank of England (BoE) have opted to maintain the status quo regarding policy rate/stance of monetary policy. Inflationary pressures have softened but recovery of growth is hesitant and/or uneven.

The IMF/World Bank however interpret global growth as resilient despite high policy rates. Stakeholders expect central banks to reduce policy rates at the earliest. Why do central banks hesitate to change their stance and cut the policy rate? Is it premature to do so?

During the Global Financial Crisis (GFC) many central banks not only reduced policy rates but reached the zero lower bound quickly. Moreover, quantitative easing was pursued by many central banks through innovative instruments. The burden of reviving the economy disproportionately fell on central banks.

As commodity prices were benign, ultra-accommodative monetary policy continued for a longer period. The revival of asset prices was rather quick as a fallout of pumping excess liquidity into the economy. The unintended consequences of excess liquidity were underpricing of risk, build-up of financial bubbles in the asset market, and sustaining stakeholders’ expectations of a perpetual low-interest rate regime.

Covid liquidity

Before the complete normalisation of the monetary policy, Covid-19 struck the world. The size of liquidity injection by central banks during the Covid-19 pandemic was unprecedented — each country pumping several multiples of liquidity injected during the GFC.

As soon as the pandemic was over, growth witnessed a ‘V’-shaped recovery, but liquidity conditions remained in surplus mode notwithstanding quantitative tightening pursued by major central banks.

The demand-supply mismatch of global liquidity persists leading to asset prices reaching historic highs in many countries. Asset price boom preceded the high retail inflation before the GFC. Central banks do not want to commit the same mistake once again by loosening the monetary policy prematurely. The possibility of central banks leaning against the asset price boom cannot be ruled out.

After all, monetary policy is forward-looking. Inflation and growth projections matter much more than the current inflation and/or growth. If inflation is moving southward, it may converge to the target sooner or later.

Given the domain knowledge, central banks provide the best projections of inflation and growth and revisit the same frequently depending on evolving macroeconomic conditions, both domestic and global. Why do they want to secure inflation at the target on an enduring basis when inflation expectations have been mostly anchored?

Central banks do not like to lower the guard quickly for multiple reasons. First, geopolitical tensions — Russia-Ukraine war, Israel-Palestine conflict, and disruption of cargo movement in the Red Sea — persist, which prevent normalization of supply chains.

Second, there are global uncertainties about the prices of primary commodities — both food and fuel — which weigh on the last-mile deceleration of retail inflation to the desired level. Third, global growth is slowly looking up despite high policy rates with clear signs of a soft landing. Fourth, the unemployment rate is below 5 per cent in many systemically important developed countries.

Case for cut

Delays in taking rate cut decisions may harm the economy. To be on the safe side, it is better to look at the real policy rate of a sample country (Table 1). Conventional wisdom suggests that the real policy rate should be lower than the real GDP growth. The ideal real policy rate for the developed country is difficult to prescribe, but it would be somewhere between 0.5 and 1 per cent.

Unfortunately, among the developed countries, the real policy rates in the US, UK, and EU have been higher than the real growth rates. They cannot afford to delay the rate cut any longer as that may harm growth. These central banks may start the rate-cutting cycle in the second half of 2024.

However, the rate-cutting cycle this time is expected to be short and limited to 50 to 100 bps. Japan is an outlier as the real policy rate is negative. Japan has abandoned the negative policy rate due to rising inflation.

Among the emerging market economies, the real policy rate is well above the real GDP growth in Brazil, Russia and South Africa. The central banks of both Brazil and South Africa have the scope to cut the policy rate at the earliest to support growth while Russia may do so subject to the lifting of American sanctions due to war with Ukraine.

As the retail inflation is low, China has already reduced its policy rate by 10 bps recently. China’s policy rate is one of the lowest among the peer group. Hence, further rate cut in China is limited, although desirable to prevent a growth slowdown.

India’s real policy rate at 1.4 per cent is the lowest in the sample barring China. As the economy is growing close to its potential, the real interest rate of around 1.5 per cent may be treated as an equilibrium real interest rate. India’s growth momentum is sustained with robust macroeconomic fundamentals.

However, headline inflation remains above the target despite a fall in the core inflation. Amidst global uncertainties, India’s retail inflation is expected to soften to 4.5 per cent by March 2025 and 4 per cent by March 2026.

Hence, the RBI has valid reason to maintain the status quo for the time being.

The writer is currently RBI Chair Professor at Utkal University and former Head of the Monetary Policy Department, RBI. Views expressed are personal.