RBI policy a cautiously constructive hold; focus on liquidity management

Disclaimer: This article is written by Madhavi Arora, chief economist, Emkay Global Financial Services. Views expressed are his own. Readers' discretion is advised. 

Unchanged rates; cautious but constructive tone

The RBI MPC has kept policy rates and neutral stance unchanged this week while reinforcing a data-driven wait-and-watch approach. There were no material changes in growth and inflation forecasts from June (10bps +/- for growth/inflation). The policy tone stayed cautiously constructive, highlighting resilient domestic growth momentum and FCNR inflows while acknowledging geopolitical, global financial market, and El Niño risks. 

 

In recent weeks, Brent volatility has been pronounced, highlighting the need to closely monitor geopolitical developments, as well as, global financial conditions amid shifting expectations for Fed policy. At the post-MPC press conference, discussions largely centred on FCNR+ inflows and the RBI's approach to INR management. However, little new information emerged, beyond the RBI reckoning liquidity impact peaking in 2Q with healthy flows ahead, with RBI using various conventional tools to manage liquidity as needed. 

 

 

Inflation forecast trimmed by a modest 10bps…

The 30bps undershoot in 1Q CPI inflation vs the RBI's forecast has led to mild downward revision to its FY27 inflation forecast by 10bps to 5.0 per cent (Emkay: 5.0 per cent). However, the cautious yet balanced tone on headline was retained driven by West Asia geopolitical risks and El Niño-related weather uncertainty, with headline inflation peaking in 3QFY27. We believe the RBI's forecast already embeds some monsoon risk, but the Governor reiterated upside food shock risks owing to El Niño-related disruptions, while acknowledging comfortable buffer stocks. This somewhat cautious tone on headline and food inflation was offset by repetitive mention that underlying inflation pressures core-core inflation (core-ex precious metals) is still benign (currently at 2.5 per cent). The core inflation forecast has been revised down more dramatically by 40bps to 4.3 per cent from June, nearly back to their April forecast. However, there was a recognition that core-core inflation will eventually catch up with core inflation by end-FY27. We see that largely owing to the base effect and see headline inflation averaging at 5.0 per cent, with core and core-core inflation averaging ~4.6 per cent and ~3.7 per cent respectively in FY27.

 

…while growth resilience prompts a mild 10bp upward adjustment

On growth, the MPC retained a constructive assessment, supported by robust 1QFY27 growth momentum led by high-frequency indicators, that suggest limited spillovers from the ME conflict so far. Expectedly so, as Credit growth, auto sales, early 2Q corporate earnings and industrial activity all seem to point to a cyclical recovery gaining traction. That said, downside risks from geopolitical tensions and El Niño-related weather uncertainty remain. The MPC noted risks to agricultural output and thus rural consumption due to monsoon vagaries, but strong allied sector growth and government schemes are expected to partly mitigate the adverse impact. On net, the RBI raised its FY27 growth forecast mildly to 6.7 per cent from 6.6 per cent earlier with balanced risks (Emkay: 6.3 per cent, with upside risk).

 

Focus ahead on FCNR inflows and liquidity management   

The RBI's June capital inflow measures have provided significant policy space to remain on pause, with the FCNR+ window yielding $41 billion so far. This is expected to lift FY27 BoP surplus to ~$35 billion-plus with CAD/GDP ~1.5 per cent, supporting INR stability, boosting FX reserves, and allowing the RBI to focus on the domestic growth-inflation trade-off rather than external vulnerabilities. That said, banking system liquidity surplus remained moderate in July, averaging ~₹1.0 trillion, despite estimated core liquidity being ~₹5.5-6 trillion by end-July, owing to elevated govt cash surplus.  However, the early August liquidity spike partly reflects government spending. More broadly, a significant portion of the liquidity injected into the system is being offset by the RBI allowing existing buy-sell swaps to mature, alongside likely spot FX intervention. Meanwhile, unimpressive INR movement also mirrors weak EMFX dynamics. While the RBI's net short forward book will decline as near-term swaps are allowed to mature, these will largely be replaced by longer-tenor FCNR+ swaps in RBI’s forward book. Separately, core liquidity is likely to peak in 2QFY27 before normalizing in 2H as the FCNR+ window closes and currency leakage rises. Consequently, the RBI is more likely to use temporary liquidity absorption tools than tighten its policy stance or rates ahead, while system liquidity should improve as government spending accelerates.