US tariffs pose downside risk to aggregate demand, says RBI report

Headline inflation to remain significantly below target this year; S&P upgrade bodes well for yields

The India-US trade policies pose a downside risk to aggregate demand, which is holding up so far due to benign financial conditions along with ongoing transmission of rate cuts, supportive fiscal measures and rising household optimism, the Reserve Bank of India’s (RBI) monthly State of the Economy report said.

 

 The report also said inflation outlook for the near term has become more benign than anticipated earlier and headline inflation is likely to soften further below the 4 per cent target in the second quarter before inching up in the last quarter of the financial year. “Overall, the average headline inflation this year is expected to remain significantly below the target,” it said.

 

 

Monetary policy, going forward, the report said, would continue to maintain a close vigil on the incoming data and the evolving domestic growth-inflation dynamics to chart out the appropriate monetary policy path.

 

The report further said that the sovereign rating upgrade by S&P bodes well for the bond markets while enhancing the credibility of monetary policy, and it may lead to lowering borrowing costs. “India’s sovereign rating upgrade by S&P bodes well for capital inflows and sovereign yields, going forward,” the report said.

 

S&P Global Ratings had upgraded India’s long-term unsolicited sovereign credit rating to ‘BBB’ from ‘BBB-’, while also raising the short-term rating to ‘A-2’ from ‘A-3’. “The S&P’s sovereign rating upgrade for India, under-pinned by buoyant economic growth, enhanced monetary policy credibility and government’s commitment to fiscal consolidation, could potentially lead to a reduction in borrowing costs, greater investor confidence and higher foreign capital inflows, going forward,” the report said.

 

Further, it noted that government bonds yields fell following the rating upgrade, only to reverse trend the very next trading session on government’s announcement to rationalise GST rates.

 

The report cited trade related issues for the hardening on sovereign bond yields. “In the fixed income segment, 10-year G-sec yields hardened during mid-July to early August amidst uncertainties over India-US trade talks and subsequent tariff imposition by the US. The S&P’s upgrade of India’s sovereign rating on August 14, 2025 led to a brief easing. Thereafter, yields hardened during the third week of August,” it said. The high frequency indicator exhibited a mixed trend in July.

 

“Various high frequency indicators of domestic economic activity showed a mixed trend in July, with goods and services tax (GST) e-way bills scaling a record high and GST collections registering a robust growth, but electricity demand remained subdued,” it said.

 

Observing that demand in rural areas continued to show resilience, the report noted the timely progress of southwest monsoon which has helped boost kharif sowing. “An increase in real rural wages may support rural demand in the second half of the financial year,” it said. Industrial activity remained subdued in June, dragged down by mining and electricity. At the same time, lead indicators for manufacturing and services activity showed sustained expansion in July.

 

 On the India-US tariff issue, the report said though the current exemptions from tariff alleviate the immediate impact, exports in some sectors may get negatively impacted.

 

The financial conditions remained benign during July and August (until August 21). Amidst surplus liquidity, the weighted average call rate (WACR)  was in the lower half of the corridor. Overnight rates in the money market moved in tandem with the WACR, it said.

 

The report said net FDI inflows remained muted due to an increase in both repatriation of FDI and outward FDI even if gross inward foreign direct investment (FDI) reached a four-year high in June.

 

“India’s external sector remained resilient with a modest current account deficit and forex reserves covering 11 months of imports,” it said.

 

State of economy  

• Inflation outlook: Average headline inflation this year expected to remain significantly below the target
• S&P upgrade: Enhance monetary policy credibility, lowers borrowing costs ahead
• Bond yields: Volatile amid trade tensions, GST rationalisation
• Rural demand: Monsoon, higher wages to aid consumption
• Industrial activity: Subdued in June, services, manufacturing expanded
• GST collections: Robust revenues; e-way bills at record
• FDI flows: Gross inflows at four-year high in June
• Forex reserves: Cover 11 months of imports, resilient