By B Prasanna | Sameer Narang
In his first monetary policy, the Reserve Bank of India (RBI) governor has emphasised how the flexibility incorporated in the flexible inflation targeting (FIT) regime has worked well for India since its introduction, along with a trade-off between new regulatory measure and cost of regulation, and last but not the least providing both durable and overnight liquidity. The Monetary Policy Committee (MPC) reduced the repo rate by 25 basis points (bps) to support growth, as inflation is increasingly aligning with the target, while keeping the stance as neutral.
The RBI reduced its growth forecast for FY26 to 6.7%, lower than the 7.1% in October but the same as the December bulletin. Hence, the MPC has endorsed the growth projection laid out in December given the slowdown in urban consumption. The governor is optimistic about achieving growth in 2025-26 on the back of the reduction in income tax in the Budget, which should incentivise consumption and thus investments along with buoyant rural growth and agriculture production. We believe growth should settle at 6.5% in 2025-26, closer to the MPC’s projection.
However, the RBI has revised its inflation projection for 2025-26 marginally to 4.2% from 4.1% in October. The revised number is higher than the December bulletin projection of 3.8%. What has changed? A weaker currency has tilted the balance along with the uptick in global commodity prices, which would be passed on to domestic consumers with a lag. Correspondingly, core inflation is expected to increase from the lows seen in 2024-25 even as food inflation is expected to moderate. Notably, food inflation has been largely driven by vegetable prices this year at 26.3%; the moderation seen now implies food and there consumer price index inflation should head lower.
The evolving growth-inflation dynamic has given space to the MPC to unanimously vote for a rate cut. At the same time, the stance has been kept neutral when a few market participants were hoping for a change to accommodative. The rationale for neutral is excessive volatility in global markets and uncertainty in trade. Since the previous policy, INR has depreciated by 3.2% against the USD which in turn has appreciated by 1.5% against a broader set of currencies. But Asian currencies have been falling since October 2024 after US elections on the back of expectation of higher tariffs on China; INR has caught up with the trend now.
While the dollar index has receded from its recent high after President Trump postponed tariffs on Mexico and Canada by a month, the tariff albatross would continue to hang around the neck of global markets in the foreseeable future. Combine this with the elevated fiscal deficit in the US and prospects of higher than lower interest rates, and the Fed perhaps looking to reduce rates later than sooner. Hence, it may be appropriate for the MPC to maintain its neutral stance but reduce the repo rate further so that real rates are brought down to support growth. This makes a case for another 25-bps rate cut in April.
Given that the RBI had already announced liquidity measures of Rs 1.5 lakh crore on January 27 and had begun to do open market purchases, further measures on liquidity were not announced today. But the governor comforted the markets by emphasising that liquidity will be provided “proactively”. However, in a neutral stance the RBI’s endeavour would be to provide enough liquidity so that it is closer to neutral. The measures taken so far show that supply and demand for durable liquidity should suffice for now. However, if foreign portfolio investment (FPI) outflows increase more measures would be needed. For the next year, we believe the RBI would have to conduct open market operations not only to neutralise the run-off of securities maturing in its balance sheet but also to inject durable liquidity given a moderate balance-of-payments surplus along with reduction in the cash reserve ration, buy-sell swaps, and longer-tenor variable repo rates.
As a regulator of banking, the governor emphasised that the regulatory framework would incorporate balancing the trade-off between financial stability and cost for the financial system by focusing on improving efficiency. To this end, the implementation of the recently announced steps on liquidity coverage ratio (LCR) and expected credit loss would be done in a phased manner. With only two months left in the current financial year, the earliest that LCR regulations may see the light of day would be March 2026 with phased implementation. This implies lower demand for government securities than otherwise in 2025-26.
Given the global volatility and uncertainty amid the recent downturn in the economy and a depreciating currency, the MPC had to do a tough balancing act. It has done so by reducing the repo rate but maintaining its stance. In terms of market reaction, the 10-year yield went up post-policy and INR gained against the dollar. With expectations of another rate cut in April, we expect the 10-year yield to remain in the 6.6-6.75% range in the near term. In case of INR, we believe a depreciation bias should continue given the FPI outflows from emerging markets amid threats of tariffs and elevated yields in the US. A trend reversal should happen but its timing is uncertain as of now.
The writers are head-treasury, and head-economic research group, ICICI Bank.
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