The Reserve Bank of India's Monetary Policy Committee (MPC) is set to make a critical decision this week, navigating a complex economic landscape marked by surprisingly low inflation and robust growth figures. The central bank's strategy of maintaining a liquidity surplus in the banking system throughout 2025-26 is now seen as the pivotal tool for ensuring that any future rate cuts effectively translate into lower borrowing costs across the economy.
The Growth-Inflation Conundrum
The MPC's decision is complicated by sharply diverging data. Consumer Price Index (CPI) inflation plummeted to a series low of 0.25% year-on-year in October 2025. The RBI has already slashed its average inflation forecast for 2025-26 by 160 basis points, from 4.2% in February to 2.6% in October, with another significant downward revision expected soon.
On the growth front, the picture remains strong but mixed. GDP growth averaged 8% in the first half of 2025-26 and is projected to exceed 7% for the full year. However, nominal GDP growth of 8.7% is among the weakest readings in nearly five years. While corporate earnings and consumption showed strength, driven by tax rebates and festivals, the recovery is uneven. Premium housing and automobile sales are leading, whereas broader consumer confidence, especially in urban areas, remains in the "pessimistic" zone.
Sticky Bond Yields and Hesitant Transmission
Despite a 100 basis points reduction in the repo rate between February and October 2025, the transmission to the broader economy has been incomplete. Fresh bank deposit and lending rates fell by 105 bps and 69 bps respectively. However, the debt market has been stubborn. The benchmark 10-year government bond yield declined by a mere 15 basis points during the same period.
Several factors are contributing to this stickiness:
- Concerns over higher government borrowings following tax reforms.
- The RBI's interventions in the currency market to manage the rupee's volatility.
- Spillover effects from volatility in longer-term global bond yields.
This hesitant transmission underscores the challenge facing policymakers.
Why Liquidity is the Linchpin
Recognizing this hurdle, the RBI has proactively ensured a surplus liquidity environment in the banking system. This active liquidity management is designed to accelerate the pace at which policy rate changes affect real economy lending rates. Economists argue that clear and emphatic guidance from the RBI on continued liquidity support is now the most effective measure to soothe bond yields.
Lower and stable bond yields are essential for a broader softening of lending rates for businesses and individuals, thereby stimulating investment and consumption.
Broader Economic Headwinds
The outlook is clouded by external and internal pressures. Global trade friction and policy uncertainty have surged, with the IMF's World Uncertainty Index doubling since January 2025. India's merchandise trade deficit has hit a record, partly due to high bullion imports. Notably, the Indian rupee depreciated 4.5% against the US dollar in 2025, even as the Dollar Index itself fell over 8%.
Domestic credit growth presents another mixed signal. While overall bank credit grew 11.3% year-on-year in October, excluding gold loans, growth was a tepid 8%. In an unusual trend, the number of active loan accounts in the banking system fell by 1.4% year-on-year, and by 3.3% in the nine months ending September 2025—a decline not seen even during the pandemic, particularly affecting small borrowers.
In summary, with inflation well-controlled and growth holding up, space for monetary policy support has re-emerged. The consensus among experts points to a potential 25-50 basis points reduction in the repo rate in the current cycle. However, the final impact on the economy will hinge not just on the rate cut itself, but on the RBI's ability to use liquidity as a lever to ensure smooth and full transmission to the bond market and, ultimately, to borrowers across India.
