By Prasanna Balachander
The Reserve Bank of India’s (RBI) policy on Friday had many surprises. As if the jumbo repo rate reduction of 50 basis points (bps) was not enough there was also the 100-bps cash reserve ratio (CRR) cut from 4% to 3% — and then add to it a change in stance to neutral from accommodative. The change in stance to neutral implies this is essentially front-loading of the policy space, which opened up because of inflation falling below target this year after a span of six years. In a neutral setting, the RBI is now data-dependent and if growth disappoints below the current trajectory then room may open up for more easing.
The rationale for a 50-bps cut is essentially to front-load the room to cut in June and August policies at one go. This will ensure loans, in particular external benchmark-linked ones, get re-priced sooner than later and thus increase disposable income in the hands of borrowers. For other loans, the pace of transmission is critical and dependent on liquidity as well as cost of deposits. On the liquidity front, the RBI has infused Rs 9.5 lakh crore in this calendar year led by open market operation (OMO) purchases of Rs 5.2 lakh crore. This has led to much deeper reduction in shorter-end interest rates than policy rate. For instance, before the announcement of the 50-bps cut on Friday, the weighted average call rate (WACR) had already fallen by 70 bps, three-month T-Bill by 88 bps, and three-month certificate of deposit rate by 138 bps which is much more than the repo rate cut. Faster and deeper reduction in deposit cost should be visible in transmission and thus support growth.
In order to support transmission, the RBI also reduced the CRR by 100 bps, albeit from September. This in itself is likely to free up as much as `2.5 lakh crore of deposits with the central bank which can be used for lending or buying government securities. The CRR reduction has greater (positive) implication for the money multiplier and the medium-term growth of broad money that in turn will support greater credit expansion. Earlier, the RBI had also tweaked the liquidity coverage ratio regulations, which meant around `3 lakh crore of funds are made available for lending rather than buying high-quality liquidity assets against deposits. These steps reduce the cost of regulation on the banking system, and are a positive for margins thereby speeding up transmission.
The RBI has been in a position to front-load reduction in interest rates since inflation has seen a sharp reduction, now at a six-year low, and outlook is favourable. First, crude oil prices have fallen to $65 per barrel as against an average of $78 per barrel last year. Second, food prices have seen a sharp moderation led by pulses and vegetables. Third, given an above normal monsoon, output should likely increase having a salutary effect on prices. Fourth, given the headwinds, industrial metal prices too are easing (down by 7% from a peak in March). Lastly, the US-China trade war has the potential for China to find non-US markets to sell their goods which can have a dampening effect on prices. Gold prices (and their effect on core inflation) are the only fly in the ointment. The RBI has revised its inflation trajectory lower to 3.7% from 4% with the decline driven by food inflation and concentrated in H1. It has not changed its March 2026 inflation projection and projected above 4% for FY27. Hence, if inflation proceeds on this trajectory then even with real rates of 1.5% the current policy rate seems reasonable. Further cuts can be justified only if inflation falls off even more, or if growth takes a sudden dip requiring real rates to be lower.
Thus the RBI’s change of stance can be explained by the fact that the current policy room has been fully used up at one shot. In a neutral stance, the RBI is data-dependent and thus any downward surprise on growth can open up room for further accommodation. The other factor which can create room for further reduction in rates is the US Fed interest rate trajectory. After reducing rates by 100 bps, the Fed has been on a pause this year given the uncertainty of the impact of tariffs on inflation. Recent high-frequency indicators are pointing towards slower growth and faster deceleration of core services inflation. If tariffs aren’t as inflationary as is being feared, then the Fed would be looking at reducing real rates from current levels of more than 2%, which is positive for emerging market central banks.
On the relationship between stance and liquidity, the governor emphasised that the liquidity framework is being looked into. From a durable liquidity perspective, the announcement of CRR cut starting from September — when demand for currency picks up — has probably been made to signal to the banking system that the liquidity will be kept in surplus in the second half even when the large forward dollar short position matures (and sucks out liquidity). But this also implies limited room for OMO purchases later in the year. What can open up room for further injection of durable liquidity is only based on the quantum of foreign inflows or outflows from a balance of payment perspective. It is only when a substantial outflow happens that there is a case for OMO purchases or a buy-sell swap in the second half considering the CRR is unlikely to go down further from here.
In a nutshell, one can describe this policy as one for the real economy and the multiple stakeholders at large (with lower EMIs and borrowing costs) and not necessarily for the financial markets and bond traders who always want the carrot (potential for more rate cuts) dangling in front of them rather than being taken away.
The writer is Head-treasury, ICICI Bank.
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