Navigating the Impossible Trinity

When was the last time we saw Twin deficits dominating headlines? Likely in 2011, when both the fiscal and current account deficits posed significant risks to India's economic stability. Since then, India has made notable strides in reducing both deficits, driven by reforms in fiscal management. During those days, both the US Fed and the RBI were navigating the aftermath of the 2008 financial crisis, adopted accommodative monetary policies. The U.S. maintained near-zero interest rates during 2010-2011 to stimulate economic recovery, while India, facing high inflation, set the repo rate at 8.5% by late 2011 to balance growth and inflation control.

Fast forward to 2024, the global environment presents familiar challenges in a different context. While the US Fed has shifted to a rate-cutting cycle with a 50 basis point cut in September 2024, reducing the rate to 4.75%, India’s inflation remains elevated. The RBI, chose not to cut rate and maintain it steady at 6.5% in its latest MPC, prioritizing inflation control and rupee stability. However, the external environment is one that is uncertain, with external shocks.

Since beginning of October 2024, the RBI has faced record equity outflows due to heavy FII selling, forcing it to sell $10 billion from its forex reserves. This intervention, equivalent to 1.5% of India's reserves, is the largest in two years, signaling a certain level of caution. Commodity price shocks though not as severe as they were in 2011, but factors like supply chain disruptions and rising edible oil prices (take-on-rate-cut) could still pressure both inflation and growth. Additionally, the RBI Governor’s statement that 'a rate cut may be risky' reflects the central bank’s cautious approach.

The Impossible Trinity—managing capital flows, maintaining currency stability, and exercising independent monetary policy—remains at heart of RBI’s current challenge. The interest rate dynamics of 2011 and 2024, though in different global context, are shaped by similar external shocks, inflation pressures, and capital flow volatility, guides the RBI's current policy decisions, and for the time being, seems to prioritizes inflation control ahead of growth.