Monetary policy: Innovative, out of box, and 'Lucas unanticipated surprise'

After pandemic, this is the first time RBI has reduced policy repo rate by 50 bps to 5.5%

Today’s monetary policy committee (MPC) statement may be unexpected for the wider market in terms of the quantum of rate cuts but was in line with our assessment of ground reality and the needs of the economy. A robust gross domestic product (GDP) growth in the March quarter and broadbased falling inflation prepared the ground for the jumbo rate cut.

 

After the Covid-19 pandemic, this is the first time that the Reserve Bank of India (RBI) has reduced policy repo rate by 50 basis points (bps) to 5.5 per cent. This frontloaded larger cut will reinvigorate a credit cycle. The cumulative reduction of 100 bps in repo rate will transmit to both assets and liabilities. Banks have already reduced interest rates on savings accounts to 2.7 per cent. Also, fixed deposit (FD) rates have been reduced in the range of 30-70 bps since February 2025. Transmission to deposit rates is expected to be strong in the coming quarters with further rate cut in deposits expected from banks.

 

Further, the staggered cut in cash reserve ratio (CRR) by 25 bps starting September would release primary liquidity of about ₹2.5 trillion into the banking system by December 2025. Besides providing durable liquidity, it will reduce the cost of funding of the banks. However, the current frontloading of the rates, including the CRR cut, entails that the headroom for monetary policy has narrowed considerably for the rest of FY26. This has triggered a change in the stance from accommodative to neutral and the future decision will be conditional on the incoming data and evolving situation. The reduction in CRR will positively impact margins (5-6 bps on net interest margins) of banks and will have an impact on marginal cost of funds (MCLR) of banks at a future date.

 

Importantly, the CRR cut will reduce the ‘M0’, so the money multiplier will increase by 20-30 bps. This will bolster M3 growth in an inflation-targeting regime and will independently bolster M3 growth even as RM growth may be lower. The assessment of the growth dynamics largely reflects the policy stance. The GDP growth glide path for FY26 is projected at 6.5 per cent, with quarterly growth projections unchanged. The sustained rural economic activity bodes well for rural demand, while continued expansion in the services sector is expected to support the urban demand revival.

 

With the moderation in trade deficit in Q4FY25, alongside strong services exports and remittance receipts, the current account deficit (CAD) for FY25 is expected to remain low and within the sustainable level. However, trade uncertainty remains the key variable to monitor in FY26.

 

The financial stability considerations and risk have receded in FY26 with banks posting good profits in FY25. The system-level parameters of non-banking financial companies (NBFCs), too, are sound with comfortable capital position and improved gross non-performing assets (GNPA) ratios. The current MPC stance only strengthens the position further. Going ahead, the trajectory of the monetary policy will be data-dependent and an evolving situation. As global uncertainty becomes more complex, it has become even more important to focus on domestic growth amid sustained price stability, which the MPC has delivered today. Also, the large transfer of the RBI profit has improved headroom for fiscal policy to achieve the necessary stabilisation. Overall, the MPC stance is timely, credible and in sync with the evolving situation

 

The author is Member, 16th Finance Commission and Group Chief Economic Advisor, State Bank of India