Liquidity will be most effective for further rate transmission, soothing bond yields
With inflation at a series low and GDP growth surpassing expectations, the MPC faces a challenging decision on the repo rate. A potential 25-50 bps cut is likely in the current cycle to support liquidity and economic stability.
The Monetary Policy Committee’s decision on the repo rate later this week will be a complicated one. Inflation has receded much faster than the central bank’s forecasts. The October Consumer Price Index inflation print, at 0.25% year on year, has come at a series low.
The Reserve Bank of India’s forecast for average CPI inflation for 2025-26 has been revised lower by 160 basis points in just eight months from 4.2% in February to 2.6% in October. Another large downward revision later this week looks imminent, potentially taking the forecast closer to the central bank’s lower tolerance band of 2%.
On the other hand, GDP growth continued to spring large upside surprises to average 8% in the first half of 2025-26 and looked set to grow well over 7% during the full year. However, the latest nominal GDP growth of 8.7% is one of the weakest prints in almost half a decade.
The earnings of several companies surprised on the higher side during Q2. Consumption has picked up, aided by tax rebates and festivities, but its trend remains mixed, with recent housing and automobiles sales indicating that sales of premium products are doing the heavy lifting.
Industrial activity has also been a mixed bag – a recent survey by the Small Industries Development Bank of India pointed to a slight moderation in business optimism among Indian micro, small and medium enterprises (MSMEs). A recent survey by the National Bank for Agriculture and Rural Development (NABARD) highlighted that a lower percentage of the rural population reported a rise in income and consumption. Urban consumer confidence continues in the “pessimistic" zone, as per an RBI survey, despite inching higher.
Cloudy outlook
Trade friction and policy uncertainty continue to cloud the economic outlook, with the International Monetary Fund’s World Uncertainty Index doubling since January. India’s merchandise trade deficit widened to a record in recent months, driven partly by higher imports of bullion, and exporters scrambling to maintain competitiveness amid high US trade tariffs.
Despite India’s healthy forex reserves and markedly favourable macro-financial dynamics on most counts, the Indian rupee depreciated by 4.5% against the dollar during 2025 even as the US Dollar Index (DXY) depreciated over 8%.
Bank credit grew 11.3% year on year at the end of October, moving higher – albeit modestly – in recent months. However, digging a notch below the headline reveals that bank credit excluding gold loans grew merely at about 8%. The contribution of gold loans (around 220 bps) to bank credit had been higher than that of housing loans (about 180 bps) and loans to MSMEs and large industries (about 215 bps).
Furthermore, in an extremely unusual development, the number of active loan accounts in the Indian banking system declined 1.4% year on year, and even more rapidly (3.3%) during the nine-month period ended September 2025. Such a drop over consecutive quarters has never been the case for the Indian banking system, not even during the covid pandemic. The decline was visible across most regions and was more pronounced in the case of small borrowers.
To speed up rate transmission, the RBI kept liquidity in the banking system in surplus all along during 2025-26 through a string of proactive moves, underscoring an active liquidity management approach.
Hesitant transmission
The weighted average interest rate on banks’ fresh term deposits and lending rates fell by 105 bps and 69 bps, respectively, during February to October, when the repo rate was lowered by 100 bps. However, transmission has been considerably limited and hesitant on the debt market side, with the benchmark 10-year yield moving lower by only about 15 bps during this period.
Lingering concerns over higher borrowings on the back of tax reforms, the RBI’s currency market interventions and bouts of volatility in longer-term global yields have been some of the key factors in keeping domestic yields sticky. A clear and emphatic guidance of continued liquidity support will be most effective to help soothing bond yields at this juncture and, thereby, towards further softening of lending rates.
In sum, several MPC members have recently flagged that space for monetary policy support has re-emerged, given the recent growth-inflation dynamics. It is widely perceived that another 25-50 bps easing in the repo rate is possible during the current cycle, barring any major unforeseen surprise.
However, along with appropriate sequencing and signalling, a supportive liquidity condition can be the key to further rate transmission in the desired direction.
Siddhartha Sanyal is chief economist and head of research at Bandhan Bank. The author thanks Sudarshan Bhattacharjee and Gaurav Mukherjee for assistance. Views are personal.
topics
