By Upasna Bhardwaj, Chief Economist, Kotak Mahindra Bank
The upcoming Monetary Policy Committee (MPC) meeting this month comes in the backdrop of a relatively more stable global environment compared to the previous policy as countries attempt to strike trade deals with the US, with the country’s administration willing to provide flexibility in terms of timings and tariff rates. Having said that, the global outlook remains delicate as policy uncertainty and trade frictions continue.
While the adversities on the global front may have eased lately, the high-frequency indicators in India remain mixed. Data on auto sales, infrastructure sector, steel, cement, core exports, index of industrial production, etc. suggest an early weakening trend, while travel/freight indicators appear to be robust. The tariff-led uncertainty is further expected to delay a revival in the private capex cycle.
On the other hand, we expect a normal monsoon, higher rural wages, lower inflation and cost of borrowing, along with a partial impact of income tax cuts to provide some cushion to the consumption demand. Overall, we expect the FY26 GDP estimates to be around 6-6.2% as the global risks unfold. Notably, the fiscal headroom to address softness in growth remains limited. The higher than budgeted Reserve Bank of India’s (RBI) dividend to the government along with excise duty hike-led higher revenues are expected to offset the downside risks on direct tax collections.
The inflation outlook, meanwhile, remains fairly benign, promising to average of around 3.5% in FY26 and around 4% through most of FY27. While in the near term, untimely rains may pose some upside to vegetable prices, the predictions of normal rains signal robust kharif sowing and contained food prices, capping any sustained upside to non-perishable food prices. While core inflation is expected to trend higher, much of the increase is expected on account of the surge in gold prices along with the adverse base effect.
Furthermore, the soft global commodity price cycle is expected to keep the wholesale price index inflation significantly muted. Given the low crude prices, the oil marketing companies’ gross marketing margins on petrol and diesel are currently around Rs 13/litre each. This is likely to provide a policy lever to the government to either manage inflation or fiscal slippage risk, if any, through additional excise duty hikes.
Overall, the slowing economy along with benign inflation trends provide adequate room for the MPC to continue its monetary easing path. In the upcoming policy, we therefore expect 25 basis points (bps) of rate cut along with a continued dovish guidance.
To ensure an adequate and smooth transmission, the RBI has caused stealth easing of 75 bps (despite a repo rate cut of 50 bps) through aggressive liquidity easing measures, allowing the overnight rates to drop closer to the lower end of the corridor (5.75% currently compared to the repo rate of 6%). The RBI has infused durable liquidity to the tune of Rs 8.1 lakh crore in the form of cash reserve ratio cut, open market operation purchases, and FX (forex) swaps between December 2024 and May. Core liquidity has surged to Rs 6.5 trillion currently, aided by a record RBI dividend transfer to the government. Meanwhile, the banking system’s liquidity remains comfortable but significantly lower at around Rs 2 lakh crore.
We expect the divergence between the core liquidity and banking system liquidity to persist through at least the next three-four months before government spending picks up pace to narrow the gap. Nevertheless, our estimates suggest that the banking system liquidity should remain comfortable at around 0.8-1.2% of net demand and time liabilities through the rest of 1HFY26, not warranting any immediate liquidity easing measures. While the winding down of the heavy short-forward book of the RBI (worth $64 billion in FY26) will weigh on liquidity, tepid currency leakage and government spending should help keep the banking system liquidity conditions comfortable. However, in 2HFY26 the pick-up in currency in circulation could necessitate some further liquidity easing measures given that the balance of payment is broadly expected to remain near-neutral.
Beyond the near term, we see the continued negative output creating slack in the economy, with global uncertainties further clouding the outlook. Accordingly, we see room for deeper cuts with the terminal repo rate settling lower at 5-5.25% depending on the scale of global risks. However, we recommend small steps of 25 bps each in June and August policies followed by a pause to evaluate risks. The real policy rates of 100-125 bps in the slowing economic cycle could be necessary to aid growth.
The oft-cited constraint to aggressive monetary easing to support growth is the plausible risk of financial instability as interest rate differentials between India and US narrow. We believe interest rate differentials should not be the primary factor influencing the RBI’s monetary policy decision. More so, the magnitude of bond yield differentials witnessed historically (400-500 bps) have limited standing in today’s macroeconomic backdrop where India’s fundamentals remain resilient across all structural parameters: benign inflation, low current account deficit, high import cover, and a fairly valued rupee. Accordingly, the current bond yield differentials are more a reflection of India’s robust macro position versus a relatively more precarious US debt position. We, therefore, believe the RBI has adequate degrees of freedom for now to address a slowing economy. Needless to say, it should approach the monetary easing in a gradual manner in order to balance the risks from an extremely volatile global environment.
Further, we await some guidance on the timelines and details of the new liquidity framework. Clarity is awaited on the continuation of the weighted average call rate as the operating target of the MPC, variable/fixed repo operations, any changes to liquidity adjustment facility corridor, and/or any other fine-tuning measures to ease liquidity management.
Views are personal