On RBI Rate Cut, Inflation Expectations Data, MSME Guarantee, Internship Scheme — A Talk With Prof Prasanna Tantri

Post the RBI Monetary Policy and rate cut announcement, Dr. Prasanna Tantri, Associate Professor of Finance at the Indian School of Business, shares his perspective on the implications of the rate cut, the flaw in inflation expectations measurements, and the practical impact of various budgetary measures — particularly as they relate to tax policy, internship schemes, and MSME financing.

Here's an edited excerpt from the latest conversation with Prasanna Tantri on "What This Means" podcast. (Recorded on 07 February 2025)

RBI's Rate Cut: 'Too Little, Too Late'

Diksha: The Reserve Bank of India announced a 25-basis-point rate cut, bringing the repo rate down to 6.25 per cent. This is the first rate cut in five years. How do you see this move? Do you think it has come too late, and what would you consider an ideal rate cut?

Dr Prasanna Tantri: I welcome the change in direction, even though it is overdue. At least there has been some movement, which is positive. One commendable aspect is that the new RBI Governor Sanjay Malhotra has acknowledged the trade-off between containing inflation and maintaining employment. I find it encouraging that the central bank now explicitly recognises how raising rates can adversely affect growth and jobs.

However, I do believe this cut is “too little, too late.” In my view, it should have been more than 25 basis points, and the RBI’s stance should have moved from “neutral” to “accommodative.” By remaining neutral, the RBI signals uncertainty about whether future cuts will follow, which is disappointing. At an inflation rate of around 4.2 per cent (as per their own projections), a 6.25 per cent repo rate implies a real rate of roughly 2 per cent or higher, once risk premiums for borrowers are considered. This level can be contractionary, as it may dampen growth further if not adjusted.

Moreover, the RBI often cites “inflation expectations” as a major concern, yet the data on these expectations is weak. Their survey tends to report a flat 10 per cent expectation regardless of the actual inflation rate, which is closer to 4 per cent. There is a disconnect: if people truly expected 10 per cent inflation, they would demand wages accordingly. That has not been happening on a large scale, which suggests the official measure of inflation expectation needs to be refined.

Diksha: What tangible impact do you foresee from this 25-basis-point cut in terms of consumption and investment say in the next six to nine months? Will it encourage activities such as home purchases?

Dr Prasanna Tantri: A 25-basis-point cut alone is unlikely to significantly change the borrowing decisions of individuals or businesses. Monetary policy works with “long and variable lags” — it can take two or three quarters for the effects of any rate change to manifest in the economy. Given that this cut is relatively small, it will not immediately boost housing demand or revive large-scale credit off-take.

If there were a series of cuts totaling 50, 75, or 100 basis points over time, then we could expect more substantial improvements in loan affordability and consumer sentiment, which might help real estate and other consumer-driven sectors. However, right now, we still have a neutral stance, and it is unclear whether more cuts will follow.

RBI's Inflation Expectation Data Needs Urgent Fixes

Diksha: In your opinion, how should the RBI address inflation expectations measurement and the broader monetary policy framework going forward?

Dr Prasanna Tantri: The RBI must improve how it measures inflation expectations. If the central bank is primarily using interest rates to control inflation driven by items like vegetables and crude oil, it needs robust data to show that such price spikes are pushing up long-term inflation expectations and wages. If the current survey consistently shows an unrealistic 10 per cent inflation expectation while actual inflation is around 4 per cent, it suggests a flawed metric.

Moreover, we should question how effective “inflation targeting” has been in anchoring expectations. True credibility would mean that a temporary spike in prices (say, onions or tomatoes) does not automatically raise long-term inflation expectations. If the RBI still feels compelled to raise rates whenever vegetable prices rise, it implies inflation expectations remain unanchored even after years of this framework.

We also need to remember that prudent fiscal management by the Finance Minister has played a substantial role in keeping inflation lower, than the RBI’s interest-rate interventions.

Diksha: Turning to the Union Budget, many observers have pointed out that it seeks to address consumption, savings, and investments. For instance, there are tax rebates for individuals, measures for MSMEs, and additionally, income from Category I and II Alternative Investment Funds (AIFs) will be treated as capital gains and taxed at 12.5 per cent instead of as business income (30 per cent). How do you assess the budget’s impact on these fronts?

Dr Prasanna Tantri: A budget is fundamentally a statement of accounts — revenue and expenditure — so not all reforms appear directly within it. Policy decisions often happen outside the budget. Still, there are noteworthy aspects:

• Tax Cuts and Targets: The reduction in personal income taxes is admirable. However, if the government maintains high tax collection targets while cutting rates, tax authorities may be pressured to extract the same revenue through stricter enforcement or complex rules. This could undermine the benefits of tax cuts. Ideally, a lower tax rate should come with a more realistic revenue target or lower expenditure.

The government has increased its capex allocation, including funds earmarked for states. Yet there are often practical constraints. If states cannot fully utilize the funds (as happened in the past), the actual outflow could be less than budgeted. Therefore, they will not need to impose undue burdens on us in order to collect more taxes. As a result, this tax cut is likely to be genuine, leading to higher disposable income and an improved financial situation. However, there remains the possibility that things can go wrong also.

What's Wrong With MSMEs Credit Guarantee Cover

Dr Prasanna Tantri: The government continues to push credit guarantee schemes and priority sector lending to MSMEs. The main concern is that indiscriminate credit guarantees can encourage banks to lend to inefficient or stagnant small firms. In India, smaller enterprises often remain small for decades, partly due to policies that reward staying below certain size thresholds. A better approach is to channel credit to businesses with growth potential. Perpetually propping up weak enterprises risks bank stress and potential loan defaults in the long run.

Diksha: The credit guarantees have indeed expanded from a limit of Rs 5 crores to Rs 10 crores for micro and small enterprises. Could you elaborate on why this might be problematic?

Dr Prasanna Tantri: The core issue is that banks, protected by guarantees, have reduced incentives to assess a firm’s actual growth potential and creditworthiness. If the loan fails, the government steps in with insurance or a guarantee. Over time, excessive reliance on such guarantees can build up bad loans, which either become a burden on the public exchequer or encourage “evergreening” — rolling over bad debts into new loans. We saw this cycle under previous governments, where non-performing assets were understated, eventually leading to major banking-sector stress.

Supporting vibrant, innovative small firms is good policy, but it cannot be done simply by guaranteeing all MSME loans. Businesses that fail should be allowed to exit, so capital and labour can move to more productive sectors. That is how economies grow.

On The PM Internship Scheme

Diksha: Regarding employment, the Finance Minister has increased allocation for internship-based skill-development schemes. Do you believe they will improve job prospects?

Dr Prasanna Tantri: The idea of on-the-job training is excellent. As a professor, I'll tell you that you don't learn much in the classroom; you learn more on the job. Connecting young individuals with real work experience can build valuable capabilities. However, large-scale deployment needs thorough piloting. We must track how many interns secure formal employment afterward.

If initial pilots are small, we can refine the program before rolling it out nationwide. Otherwise, we risk logistical issues (e.g., forcing private entities to take on large numbers of interns they cannot train effectively) and losing a potentially strong initiative due to poor execution.

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