Inflation undershoots, yet risks remain: Rate cuts may spark volatility

India’s Consumer Price Index (CPI) inflation eased to 2.1 per cent year-on-year in June 2025, down from 2.82 per cent in May. For the April–June quarter, CPI inflation averaged 2.7 per cent, lower than the Reserve Bank of India’s (RBI’s) projection of 2.9 per cent. This decline, largely driven by falling food prices, may offer near-term comfort to the Monetary Policy Committee (MPC). However, a forward-looking view suggests that a more cautious approach to interest rates is warranted. 

We forecast CPI inflation to average 3 per cent in FY26, significantly lower than the 4.6 per cent recorded in FY25. In the absence of a food price shock, inflation is expected to remain subdued in the near term—around 2.5 per cent in July–September and 2.6 per cent in October–December — well below the RBI’s forecasts of 3.4 per cent and 3.9 per cent, respectively. While inflation is likely to converge with the RBI’s estimate of 4.4 per cent in the final quarter of FY26, the undershoot in the first three quarters pulls down the full-year average to 3 per cent, 70 basis points lower than the RBI’s current forecast of 3.7 per cent. 

However, this benign phase is unlikely to last. The sharp drop in CPI inflation this year will create an unfavourable base for the next fiscal year. Our estimates suggest inflation will rise to 5 per cent in April–June 2026, before moderating to 4.7 per cent and 4.4 per cent in the following two quarters. As a result, CPI inflation is expected to average 4.5 per cent in FY27  — a marked increase from FY26’s likely average of 3 per cent. 

Historical patterns reinforce this outlook. From November 2018 to January 2019, CPI inflation averaged just 2.1 per cent. A year later, it surged to over 7.5 per cent due to base effects and rising food prices. Similarly, CPI hit a low of 1.5 per cent in June 2017, only to rebound to nearly 5 per cent by mid-2018. These past episodes show how inflation can quickly rise following periods of exceptionally low readings, particularly when food prices are involved. Given India’s inherent food price volatility, the current disinflation could reverse quickly, potentially pushing inflation towards the upper end of the RBI’s target band by mid-2026. 

Against this backdrop, a forward-looking MPC should exercise restraint. If inflation rises to 5 per cent in Q1FY27 and averages 4.5 per cent in FY27, the real interest rate — currently around 300 basis points — will compress to 50–100 basis points even if the repo rate remains unchanged at 5.50 per cent. A further rate cut, to say 5 per cent, would narrow the real rate to as low as zero, which may not be ideal for medium-term macroeconomic stability. 

The MPC’s June 2025 decision to cut the repo rate by 50 basis points — more than expected — surprised markets. In an interview (Business Standard, June 17), RBI Governor Sanjay Malhotra suggested that if inflation stays below projections, it “opens up policy space.” He also clarified that a shift to a “neutral” stance does not imply an immediate reversal of the policy cycle. While these remarks suggest the MPC may be inclined to deliver another 25 basis points  cut this year, we believe caution is warranted. 

Any further easing may be deferred until October, depending on several factors: The trajectory of food prices, the release of April–June gross domestic product data on August 29, the transmission of previous rate cuts, and the global economic outlook, particularly monetary policy in the United States, and trade tensions. These elements will be critical in determining whether more easing is justified. 

Moreover, India’s current growth outlook doesn’t necessitate additional stimulus. In 2019, when the RBI cut rates from 6.5 per cent to 5.15 per cent, GDP growth had fallen below 5 per cent, partly due to the IL&FS crisis. In contrast, despite global uncertainties, we expect India’s GDP growth in 2025 to remain robust at around 6.5 per cent. This strengthens the case for maintaining the repo rate at 5.5  per cent. 

In conclusion, while the current inflation undershoot offers short-term relief, the MPC must take a slightly medium-term view. Inflation is expected to rise meaningfully in FY27, and aggressive rate cuts now could leave the economy vulnerable to inflation volatility later. A prudent approach would be to hold rates steady, monitor developments closely, and ensure that real interest rates remain in a zone that supports both growth and price stability. 

The author is chief economist — India, Malaysia, and South Asia — Deutsche Bank AG