Monetary policy: Need to ease unrealistic burden on central banks

In recent years, central banks worldwide have faced mounting pressures to deliver both economic growth and stability through monetary policy. The Reserve Bank of India is also tasked with the dual mandate of ensuring price stability while fostering economic growth. However, as economic data from FY 2024-25 reveals, these expectations often outstrip the realistic capacity of monetary policy, creating an “expectations gap” that risks undermining public confidence in central banks.

The GDP growth slowdown in the second quarter of FY2024-25 to 5.4% — a sharp drop from 8.1% in the same quarter of the previous year — exposes the limitations of monetary policy in driving growth. The RBI’s decision to hold the policy repo rate at 6.50% reflects its commitment to macroeconomic and financial stability amidst global uncertainties. However, it also highlights the tension between inflation targeting and the broader objective of economic growth.

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The RBI monetary policy committee’s decision to maintain the repo rate, despite slowing growth, illustrates the trade-offs central banks face. Inflation projections for FY2024-25 were revised upward, from 4.5% to 4.8%, driven by food price pressures and supply chain disruptions. In such a scenario, aggressive rate cuts to boost growth could destabilise inflation expectations and erode the central bank’s credibility.

Structural challenges beyond monetary policy

The Q2 slowdown was driven more by structural factors than monetary policy. Industrial growth slumped to 2.1% from 7.4% in Q1, with manufacturing barely expanding at 2.2%. Government capital expenditure contracted by 15.47% in the first half of FY 2024-25, constraining economic momentum. While rural demand showed resilience, urban demand moderated, revealing uneven recovery dynamics.

The RBI’s dual mandate is further constrained by deeper structural challenges in India’s financial ecosystem. A key issue is the underdevelopment of India’s debt markets, dominated by government borrowing and AAA-rated corporates. This leaves smaller enterprises and lower-rated borrowers with limited access to affordable credit. Additionally, risk-averse banking practices prioritise top-rated entities, side-lining sectors critical for broad-based economic growth.

Global headwinds and policy limits

Geopolitical conflicts, financial market volatility, and geo-economic fragmentation have reshaped the global economic landscape. As noted in the RBI Governor’s December 2024 statement, these factors test the resilience of economies like India. While the service sector grew robustly at 22.3% in October 2024, merchandise exports and manufacturing remain vulnerable to global headwinds.

Monetary policy, as a countercyclical tool, can moderate these pressures but cannot resolve structural weaknesses or geopolitical disruptions. Inflation targeting, a hallmark of modern central banking, has been effective in anchoring expectations, but over-reliance on monetary policy for growth risks undermining its legitimacy.

Regulatory and institutional shortcomings

India’s financial regulatory framework remains fragmented and inefficient. Over a decade ago, the Financial Sector Legislative Reforms Commission (FSLRC) proposed streamlining regulatory structures, yet its recommendations remain largely unimplemented due to institutional inertia and vested interests. The lack of cohesive inter-regulatory coordination, under bodies like the Financial Stability and Development Council (FSDC), hampers meaningful reform. Without addressing these systemic issues, it is unrealistic to expect the RBI alone to bridge the gap between growth and stability.

Unrealistic expectations of central banks, complicating policy decisions. Media narratives and political pressures often oversimplify monetary policy as a lever capable of delivering precise outcomes for growth, inflation, and employment. However, monetary policy’s short-term effects on output are limited, with its long-term role confined to price stability.

Central bank independence, a cornerstone of credible monetary policy, is under threat. Political demands for rate cuts or liquidity injections to spur short-term growth risk undermining the autonomy needed for long-term stability. A coordinated approach aligning monetary and fiscal policy within a “region of stability” is crucial for sustainable growth.

A collaborative policy approach

India’s economic challenges demand a holistic approach. While the RBI must prioritise inflation targeting, the government must lead growth-oriented fiscal measures. Policies to boost private investment, enhance infrastructure, and promote exports are critical. A comprehensive manufacturing policy — encompassing import tariff adjustments, deregulation, and targeted incentives — could revive industrial growth.

The RBI’s recent reduction of the Cash Reserve Ratio (CRR) by 50 basis points to 4%, injecting ₹1.16 lakh crore into the banking system, is a step in the right direction. However, liquidity injections alone cannot resolve challenges such as subdued private investment and stagnating industrial output. Fiscal policy, particularly government spending on infrastructure and incentives for private investment, must play a complementary role.

Reforms addressing non-performing assets (NPAs), strengthening credit flow to SMEs, and developing deeper debt markets are essential to complement monetary efforts. Measures to attract foreign capital, such as expanding FCNR(B) ceilings, are also positive steps.

Central banks cannot singlehandedly deliver both growth and stability. The RBI’s focus on inflation targeting and macroeconomic stability is vital but must be complemented by proactive fiscal and structural policies. The expectations gap, exacerbated by political and media pressures, risks overburdening monetary policy and threatening central bank independence.

A sustainable economic strategy requires realism about the limits of monetary policy and a collaborative approach to growth. Policymakers, stakeholders, and the public must recognise that central banks set the monetary preconditions for growth but cannot serve as engines of economic expansion. Only through a balanced policy mix can India navigate global economic challenges and achieve its developmental aspirations.