By Upasna Bhardwaj, Chief Economist, Kotak Mahindra Bank
As the Monetary Policy Committee (MPC) gears up for its upcoming policy review, markets are bracing for signals that could provide guidance on the trajectory of incremental monetary easing and the outlook for liquidity conditions.
The coordinated monetary and fiscal expansion policies this year-in the form of 100 basis points (bps) of repo rate cuts, cash reserve ratio (CRR) cuts, open market operations OMO purchases, and income tax and goods and services tax (GST) rate cuts-have helped cushion the Indian economy against external headwinds stemming from delays in the US trade deal and persistently elevated tariffs.
Despite a strong policy thrust, policymakers find themselves at a critical juncture-scrutinising the resilience of the recent economic revival and deliberating on the necessity for additional measures.
One of the key uncertainties for the economy is the unclear impact of elevated tariffs on the external balances. While front-loaded exports to the US and diversification into new markets have helped cushion the blow, the adverse effects appear to have deepened for India’s merchandise trade since September. The goods trade deficit widened to around $32 billion in September and further expanded to a record high of approximately $42 billion in October. Although much of the recent weakness stems from a surge in gold imports, the full extent of tariff-related pressures remains uncertain, especially as the trade deal continues to be delayed. Recently, the policymakers announced trade relief measures to counter the headwinds to exporters arising due to US tariffs.
Notwithstanding the external headwinds, domestic demand has held ground. Economic activity has stabilised, aided by softening inflation, lower interest rates, and front-loaded government spending. Of course, much of the lift-off in consumer spending has been witnessed during the festival period with the GST cut-led euphoria. Expectedly, the discretionary spends (specifically witnessed across auto sales and white goods) have outperformed the staples. Rural demand has continued to surpass urban demand, but the recent trends suggest a narrowing of the gap as urban demand shows signs of a sequential pickup. While the recent pickup in economic activity is likely to continue through this quarter given the pent-up demand in certain sectors following the GST relief, we remain wary of the sustainability of these trends amid a likely pullback in government spending as tax collections remain tepid, a fading of urban demand after a surge in Q3FY26, and as lower food prices distort the terms of trade for farmers, taking the sheen off the robust rural demand.
Furthermore, while real GDP growth appears to be robust, nominal GDP growth, at below 10%, raises a point of concern. Persistently weak nominal growth can strain corporate revenues, tax collections, and debt servicing capacity, increasing the risk of financial instability. This could amplify vulnerabilities in credit markets and weigh on investor confidence, making it critical to monitor systemic risks closely.
While growth remains broadly firm in the near term, the inflation trends in India have been very comfortable across the board, providing room for further monetary easing. Favourable monsoons have kept food inflation well in check, while the GST-led price cuts have led to a significant downside to the core-core inflation trajectory (core excluding bullion registered 2.6% in October). The recent October inflation data confirms that inflation is tracking 80-100 bps below the Reserve Bank of India’s (RBI) forecasts for 2HFY26 and also into FY27.
We expect the FY26/27 inflation to average around 2% (RBI: 2.6%) and 4.1% (RBI: 4.5%) respectively, with the core inflation also expected to converge towards the 4% mark. Meanwhile, the plausible upside risk to food prices in the coming quarters could be offset by the record high stock of rice and wheat maintained with the Food Corporation of India. Furthermore, the benign global crude oil prices could provide room for fuel price cuts at the retail level in case of any adverse scenario.
Overall, we see a scope for an additional 25-50 bps rate cut, given that real rates remain elevated and the inflation trajectory offers comfort. Although recent economic data appears resilient, much of the momentum seems driven by festive demand and GST relief, leaving its sustainability in question.
Benign core inflation, a large scope for downward revision to the headline inflation estimates, persistent spare capacity in the economy, and continued uncertainty around global trade negotiations should prompt the MPC to deliver a 25-bps cut in the December policy, especially after the central bank has signalled scope for further easing recently in a conference (reinforcing the view from the October policy).
Moreover, the forward guidance will need to strike a balanced yet marginally dovish tone to provide markets with the reassurance required to navigate prevailing uncertainties.
Additionally, the recent pressure on INR and the consequent FX intervention has led to a tightening of system liquidity. The system liquidity has fallen to 0.4-0.6% of net demand and time liabilities (NDTL) (lower than the RBI’s preferred 1% level) since mid-September after staying elevated above 2% of NDTL for most of 1HFY26. As market sentiments remain wary amid delays to the US-India trade deal, we see room for additional pressure on INR impinging on liquidity. Overall, we see the need for `1-1.5 trillion worth of durable liquidity infusion by the RBI in the rest of sFY26. Although liquidity easing measures can precede the policy announcement, we expect the RBI to announce OMO purchases in the December policy once the full impact of the CRR cut has played out. This would help support bond markets, as the adverse demand-supply situation stabilises.