RBI's 2026 Monetary Strategy: Liquidity Emerges as the Central Focus
The Reserve Bank of India (RBI) has executed a significant shift in its monetary policy approach for 2026, moving away from traditional interest rate adjustments to prioritize liquidity management as the key driver of economic stability and growth. This strategic pivot comes after the central bank delivered 125 basis points of rate cuts in 2025, including a substantial 50 basis points reduction in June of that year.
The Transition from Rate Easing to Liquidity Support
As the Monetary Policy Committee prepares for its February meeting, expectations point toward maintaining the repo rate at 5.25% with a neutral stance. However, the real narrative of India's monetary policy this year revolves around liquidity operations rather than interest rate movements. The RBI has been actively deploying various instruments behind the scenes to ensure the financial system remains adequately funded.
Since December, the central bank has implemented a series of open market operation purchases and forex swap auctions to counteract liquidity pressures stemming from multiple factors:
- Slower deposit growth compared to credit expansion
- Foreign capital outflows affecting market stability
- Persistent intervention to stabilize the rupee exchange rate
Quantifying the Liquidity Challenge
Current estimates suggest the RBI may need to conduct approximately ₹2 trillion in OMO purchases during the remainder of FY26, with an additional ₹4 trillion anticipated in Q1 FY27. These measures aim to maintain durable liquidity above 1% of net demand and time liabilities (NDTL). The central bank will continue utilizing variable rate repo auctions of varying tenors to align overnight call rates with the repo rate.
This liquidity-focused approach represents a deliberate strategic shift. With global yields hardening and domestic credit outpacing deposits, the RBI's priority has decisively moved from further rate reductions to preserving the transmission of earlier cuts through adequate system liquidity.
Inflation Dynamics and New Measurement Framework
The inflation outlook provides the RBI with operational space to emphasize liquidity management. The central bank is expected to maintain its 2.0% consumer price inflation forecast for FY26, though the January-March projection of 2.9% might see a downward revision of 20-30 basis points. For FY27, projections likely remain at 4.5%.
A significant development arrives on February 12 with India's introduction of a new consumer price index series featuring updated weights and a fresh base year. The reduction of food weights from approximately 46% to around 37% could modestly reshape the inflation trajectory, particularly if food prices accelerate more than currently anticipated in FY27.
In the near term, headline inflation is expected to gradually rise due to adverse base effects, potentially exceeding 4.5% by the December quarter. However, core inflation remains subdued near 4%, dropping below 3.5% when excluding gold prices, as noted by RBI Governor Sanjay Malhotra in recent MPC minutes.
Growth Projections and Market Implications
The RBI is likely to maintain its FY27 growth projection at 6.6%, though this will undergo reassessment following the February 27 release of a new GDP series with updated methodology. A potential revision could nudge historical and future growth estimates slightly higher.
Market dynamics present an intriguing scenario: if the RBI were to raise its FY27 growth forecast to 7% or above while retaining its 4.5% inflation outlook, markets would interpret this as a hawkish signal. Such a combination of robust growth expectations alongside inflation drifting above target would logically shift policy focus toward potential rate hikes rather than cuts.
Bond markets have already positioned for this possibility, pricing in approximately 75 basis points of hikes by December 2027, potentially lifting the repo rate to 6%. Some research institutions anticipate the first rate hike in Q2 2027, with cumulative tightening of 100 basis points in FY28.
Transmission Challenges and Policy Response
Despite a generally benign inflation outlook and steady growth projections, the RBI faces the immediate challenge of preventing liquidity tightening from undermining the transmission of past rate cuts. Several factors complicate this objective:
- Global rate repricing has narrowed India's policy space for dovish stances
- The domestic rate-cut cycle appears complete, with an extended pause likely
- Unfavorable bond demand-supply dynamics persist despite fiscal consolidation
- Rupee depreciation pressures necessitate heavy forex intervention, draining rupee liquidity
Given this complex backdrop, the RBI's priority must focus on ensuring the financial system remains adequately funded and credit flows continue unimpeded by liquidity scarcity.
The Path Forward: Liquidity as the Headline Instrument
Looking ahead, large-scale open market operations will remain a cornerstone of liquidity support, complemented by continued variable rate repo operations to stabilize short-term rates. The Monetary Policy Committee will likely avoid further repo rate reductions to maintain favorable India-US interest rate differentials and encourage capital inflows.
Communication strategy will require careful calibration, avoiding overly bullish growth commentary that might inadvertently tighten financial conditions. The fundamental reality of India's 2026 monetary policy narrative centers not on whether rates move up or down, but on how effectively the RBI manages liquidity injection to sustain financial system operations, support credit flows, and maintain confidence through a challenging global environment.
In this economic cycle, liquidity management has transformed from a supporting mechanism to the headline instrument of monetary policy, shaping growth trajectories, market stability, and financial conditions across India's evolving economic landscape.
