RBI’s monetary policy: navigating for growth in choppy waters

The Reserve Bank of India had a challenging task in determining the course of interest rates and policy stance amidst extreme currency volatility, uncertainty in financial markets, and headwinds to growth. 

However, RBI’s monetary policy committee has unambiguously addressed these challenges by announcing a rate cut and shifting the stance from ‘neutral’ to ‘accommodative’, providing clear guidance and signalling a supportive approach to India’s growth-inflation dynamics.

These dynamics justify the ‘accommodative’ stance, creating room for a repo rate cut of 100 basis points during this cycle. Surplus liquidity conditions further enhance transmission through lower deposit rates in the banking system. By delinking its stance from liquidity management, RBI has retained operational flexibility to address liquidity needs effectively.

While the direct impact of the US’ reciprocal tariffs on India is limited, weaker global growth will affect India’s exports to the US. In our view, the additional tariffs announced so far are estimated to reduce India’s growth by 0.3% in 2025-26. 

Indirect effects, such as lower services exports, remittances and foreign inflows, will also be felt. However, lower oil prices and RBI’s policy support are expected to cushion these impacts. That is why RBI has lowered its GDP growth estimate for FY26 by only 0.2 percentage points to 6.5%.

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The effectiveness of RBI’s repo rate reductions will be driven by speed of transmission, for which the central bank is willing to provide liquidity to the tune of 1 percentage of NDTL (net demand and time liabilities). The liquidity support should ensure banks have access to funds at a lower cost than retail term deposits, which speeds up transmission.

But for more effective transmission, banks have to reduce deposit rates, which are determined by the competitive landscape and real rate of return. Given that RBI has lowered its inflation outlook for FY26 to 4% from 4.2%, real returns are far more attractive and leave room for reduction. 

This is fairly significant when seen in the context that it is after a span of six years that inflation will be aligning with RBI’s target of 4%. Given that the central bank’s estimates are based on oil prices at $70/barrel (current: $60/barrel), the odds of achieving the target are high.

In addition, food inflation too should continue to ease given a high base and higher output in the current year. Even for next year, the prediction is that the monsoon should be normal. Hence, even if global commodity prices go up from here, if India’s tariff negotiations with the US are successful, there is significant cushion for inflation to align with the target.

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With RBI’s benign domestic inflation outlook and the significant headwinds to growth emerging from the financial market volatility and the hit to global trade, RBI rightly changed its stance to ‘accommodative’. 

Governor Sanjay Malhotra emphasized that the stance gives forward guidance that RBI’s next rate action would be either a cut or a pause. We believe the current global economic environment calls for the MPC to continue to cut rates to support growth. 

Given that India’s current account deficit isn’t likely to exceed 1% of GDP even after accounting for direct and indirect impacts of the US tariffs, there is room to continue on the path of lower interest rates. MPC has the option to hold on to rates in case global volatility increases, which could drive depreciation pressure on emerging market currencies, including the rupee. 

RBI has delinked its stance from liquidity, which gives it room to modulate liquidity depending upon foreign exchange intervention and currency market volatility. But on balance, the reciprocal tariffs imply weaker US growth, which points towards a weaker dollar with the US Federal Reserve eventually cutting interest rates to support employment.

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We believe RBI has room to cut the repo rate by 100 basis points in the cycle, which is based on real rate of 1.5% given inflation is estimated at 4% in FY26 and 4.3% in FY27. For policy rates to go lower than this, growth and inflation outlook has to be much weaker or real rates have to be revised lower. 

Given India’s fundamentals, we don’t see a need to revise real rates and potential growth lower. Even RBI’s own estimates show growth is expected to pick up in FY27 to 6.7%. 

RBI’s liquidity framework is currently under review and we believe the new framework will be in sync with a surplus liquidity scenario rather than inducing a deficit. 

To summarise, given the heightened uncertainty, RBI has taken the mantle to support growth, which should limit the impact on India’s economy and allow operational flexibility on liquidity to manage volatility emerging from global headwinds. We see bond yields heading lower in the next few months.

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B. Prasanna is head of treasury at ICICI Bank Ltd and Sameer Narang is head, economic research group.