Evolving growth-inflation dynamics unlikely to permit further rate cuts

Economic hit due to US tariff decisions likely to be accentuated

The Monetary Policy Committee (MPC) on Wednesday unanimously maintained status quo on the repo rate and continued a neutral stance in its third monetary policy review meeting for FY26.

 

This was somewhat surprising. We had expected the decision to tilt modestly in favour of a 25 basis points (bps) cut, given the prevailing growth-inflation dynamics and the headroom for paring rates is likely to narrow in the near future.

 

However, the visible uptrend in future inflation readings, along with sustained uncertainty around growth outcomes, is likely to have convinced the MPC to hold the repo rate.

 

India’s headline Consumer Price Index (CPI) inflation eased to a 77-month low of 2.1 per cent in June 2025, led by the food and beverages segment, even as core inflation exceeded 4.0 per cent. However, core inflation was close to the lower end of the MPC’s medium-term target band of 2-6 per cent. We expect the headline CPI inflation to fall below this band in July 2025, to a series-low of around 1.4 per cent, before rising thereafter.

 

 

Unsurprisingly, the MPC pared its FY26 CPI inflation projection quite sharply to 3.1 per cent from 3.7 per cent earlier. However, in quarterly terms, the projection was limited to Q2 and Q3 FY26 estimates, which were brought down by around 130 bps and 80 bps, respectively. 

 

The inflation estimate for Q4 FY26 was kept unchanged at 4.4 per cent, while that for Q1 FY27 was pegged at a slightly discomfiting 4.9 per cent, magnified by a low base.

 

We broadly concur with these estimates, with the upward quarterly trajectory largely stemming from base effects.

 

The big surprise from the MPC’s meeting was that the committee stuck to its economic growth projections. The MPC maintained its estimate for India’s FY26 gross domestic product (GDP) growth at 6.5 per cent, with no changes in the quarterly prints.

 

RBI Governor Sanjay Malhotra did highlight that there is uncertainty around the prospects for external demand owing to tariff-related developments. Headwinds owing to persistent geopolitical tensions and global concerns pose risks to India’s growth outlook, he said.

 

We had expected the MPC to incorporate the impact of these elements into its growth projections, thereby lowering its growth estimates, particularly for the last two quarters of the fiscal. 

 

We have pared our projection for India’s FY26 GDP following the recent US tariff and likely penalty to 6.0 per cent from 6.2 per cent. Moreover, we believe risks appear tilted to the downside, given the subsequent verbal deadlines being touted by the US. The extent of the economic hit will likely be accentuated if the not-yet-known penalty amount is significant, which adds to the higher-than-expected currently proposed tariff of 25 per cent, making India’s exporters uncompetitive vis-à-vis other Asian competitors.

 

Even if a trade deal is struck in the near term, a dip in exports to the US is not ruled out in the second half of FY26, given the extent of the frontloading seen in such exports in the first six months of 2025. Moreover, private investment sentiment is sure to be damaged following USA’s tariff tantrum. This would undeniably delay Indian private sector’s capex plans, and underscores the reduction in our GDP growth forecast for FY26.

 

Besides, the frontloading of the Indian government’s capex in the first quarter of FY26 (Q1 FY26) implies a year-on-year contraction in the remaining quarters, in order to stay within the FY26 capex target of Rs. 11.2 trillion. Even if this target is raised, which is our base case, the extent of the growth will likely be limited to mid-single digits compared to the 52 per cent seen in Q1 FY26. Consequently, we expect the growth prints to taper down to slightly lower than 6 per cent in the second half of FY26, as against the MPC’s projection of 6.3-6.5 per cent for this period. 

 

The MPC has stressed the looming uptrend in the CPI inflation projections from August 2025 onwards while pressing the pause button on policy rates, even as it maintained its GDP growth projections. However, this suggests that a rate cut is unlikely in the October 2025 policy, as these inflation trends materialise.

 

Besides, the growth print for Q1 FY26, which will be the only one available before the next meeting, is expected to print largely along the MPC’s forecast for the quarter, and will also not provide reason for a rate cut.

 

An extended pause is now exceedingly likely, unless there are large surprises on the growth front, which lead to a material cut in growth projections. 

---

The writer is chief economist and head, research & outreach, ICRA. These are the personal opinions of the writer. They do not necessarily reflect the views of www.business-standard.com or the ‘Business Standard’ newspaper