RBI brings early Christmas: Room left for another 25-bps rate cut

If inflation undershoots RBI projections and growth faces roadblocks from trade barriers and geopolitics, another 25-bps rate cut will not be a surprise

Reserve Bank of India (RBI) governor Sanjay Malhotra has played Santa and brought an early Christmas to India.

 

After maintaining the status quo in August and October, the RBI cut the policy repo rate by 25 basis points (bps) to 5.25 per cent on Friday. The decision by the six-member monetary policy committee, the rate-setting body of the Indian central bank, at the last policy meeting of calendar year 2025, was unanimous. The stance of the policy remains unchanged – “neutral”. One bps is one-hundredth of a percentage point. 

The RBI has also taken care of the liquidity requirement in the system. It will buy government bonds through so-called open market operations (OMOs) to infuse Rs1 trillion. It will also conduct three-year USD/INR buy-sell swaps of $5 billion in December to inject durable liquidity into the system. This means around Rs1.45 trillion worth of liquidity will flow in this month. 

Such swaps serve two purposes – infuse liquidity in the system (which is sucked out because of dollar sale). At the same time, the dollar buying doesn’t allow depletion in the foreign exchange reserves. As the swaps are for three years, there won’t be any short term rollover requirement. 

The markets could not have asked for more. The Sensex rose 0.52 per cent; the 10-year bond yield dropped by 2 bps from 6.51 per cent on Thursday to 6.49 per cent and the rupee closed one paisa weaker at  89.99 a dollar.  

 

The backdrop to this policy is a decadal low of 0.25 per cent consumer price index (CPI)-based inflation and 8.2 per cent real gross domestic product (GDP) growth in the second quarter of the current financial year – both surpassing the consensus estimate on either side. In the governor's words, this is a “real Goldilocks period”. 

 

In the Malhotra regime, which will mark its first anniversary early next week, there has been a 125-bps rate cut (between February and December), the most aggressive easing since 2019. Between February and October 2019, the RBI had gone for five consecutive rate cuts, by 135 bps, from 6.5 per cent to 5.15 per cent. 

 

Incidentally, the last time when we had a 5.25 per cent policy rate in April 2010, the inflation was 9.9 per cent (March 2010) and the real GDP growth 7.4 per cent (for financial year 2010-11 or FY 2010-11). At that time, the RBI used to take into account the whole-sale price (WPI)-based inflation. CPI replaced WPI inflation in April 2014. Of course, the rate has dropped below this level even in the recent past.

 

Along expected lines, the RBI has revised the inflation projection downwards and growth estimate upwards. 

CPI inflation for FY 25-26 is now projected at 2 per cent, down from 2.67 per cent, estimated in October. This is the fourth time that the RBI has pared its inflation estimate. CPI inflation is estimated to be 3.9 per cent for the first quarter of FY 26-27 and 4 per cent for the second quarter – with risks evenly balanced. In October, it had pegged the FY26-27 first quarter inflation at 4.5 per cent.

 

The RBI’s projection for real GDP growth for FY 25-26 is 7.3 per cent, up from 6.8 per cent, estimated in October. The real GDP growth is projected at 6.7 per cent for the first quarter of FY 26-27 and 6.8 per cent for the second quarter – with risks evenly balanced. 

The MPC has gone for a cut as the growth-inflation balance, especially the benign inflation outlook on both headline and core, continues to provide the policy space to support the growth momentum. Will there be another cut, going forward?

 

The undertone of the policy is certainly dovish but there is no explicit guidance on this. The policy statement says, “The headroom provided by the inflation outlook has allowed us to remain growth supportive. We will continue to meet the productive requirements of the economy in a proactive manner while ensuring macroeconomic stability.”

 

If inflation rises to 4 per cent in the second quarter of FY 26-27, the scope for further rate cuts is limited as at the 5.25 per cent policy rate, the real rate will be 1.25 per cent. However, if inflation undershoots the RBI projection and the growth story faces roadblocks from trade barriers and evolving geopolitics, another 25-bps cut will not be a surprise. The 8.2 per cent real GDP growth in the September quarter could be a one-off, as the RBI sees growth in the first half of the next financial year coming in at sub-7 per cent. 

Not on too many occasions in the past have we seen the Indian central bank cutting the policy rate while the local currency is under pressure. The rupee breached the 90-level vis-à-vis the dollar early this week. It seems that the RBI is accepting this level – well aligned with the economic fundamentals. Of course, it will be in the foreign exchange market to iron out excessive volatility, if there is any.

 

Finally, the rate cut is a good story for borrowers – particularly the retail and small and medium enterprises, as such loans are linked to an external benchmark like repo rate or treasury bill yield. But the banks will find it challenging. Their net interest margin – loosely the difference between what they pay to the depositors and earn from loans – will be under further pressure. While the loan rates will dip, most banks are not in a position to pare their deposit rates. They need to brainstorm on their liability strategy to maintain profitability. 

 

They need to focus on their homework, in other words. 

 

The writer, a Consulting Editor of Business Standard, is an author and senior advisor to Jana Small Finance Bank Ltd. His latest book: Roller Coaster: An Affair with Banking. To read his previous columns, log on to www.bankerstrust.in X: @TamalBandyo