Yet another pause in repo rate? It's a close call for MPC

Inflation has remained benign over the last two months. Headline consumer price index (CPI) inflation had cooled to 1.6% in July from 2.1% in June, falling below the lower bound of the MPC’s target range of 4%+/-2% for the first time in eight years. It rebounded to 2.1% in August, while remaining subdued. The September reading is expected to dip to around 1.8%, taking the average for Q2 to 1.8% as well, trailing the MPC’s forecast of 2.1%.

A large part of the cooling in retail prices owing to the 22 September goods and services tax (GST) cut should be visible in the October data, which is likely to soften inflation to a series low of around 1.3%. In Icra's assessment, the GST rejig could dampen headline CPI prints by 25-50 basis points (bps) during Q3 FY26 to Q2 FY27 relative to our pre-GST cut estimates. This will necessitate a paring of the MPC’s CPI inflation projections for FY26 in the October meeting from 3.1% indicated in August.

The Q1 GDP numbers released at the end of August were significantly firmer than the expectations of the MPC, the market and Icra. GDP expansion accelerated to a five-quarter high of 7.8% in the quarter from 7.4% in Q4 FY25. This stood in contrast with the committee’s earlier forecast of a sharp slowdown to 6.5%.

However, this uptick was aided by the 52% year-on-year surge in the Government of India’s (GoI) capex and an upfronting of shipments to the US. The boost to growth from these factors is expected to dissipate considerably during Q2 and Q4. Notably, the headroom left for the GoI’s capex relative to its budget estimate for FY26 entails a contraction of 3% relative to the outgo in Q2-Q4 FY25.

Woefully, high-frequency indicators signal that the growth in economic activity softened in July-August 2025 vis-à-vis Q1 FY26. Excess rains adversely impacted activity across some sectors, such as electricity and mining. Moreover, the GST announcement on 15 August led to some deferment of discretionary purchases, and the 50% US tariffs weighed on exports and production.

Looking ahead, while the broader impact of the US penalties on merchandise exports seems negative, our channel checks across key exporting sectors that are expected to take a hit present a mixed outlook. Sectors such as auto components are coping well through proactive mitigation measures. While sectors like chemicals and metals appear capable of passing on the increased costs, if companies are compelled to absorb the tariff burden, it could significantly erode profitability. Other sectors such as textiles, footwear, seafood, and cut and polished diamonds, are facing margin pressures.

Overall, the materialization of a trade deal with the US would be key to preventing a sustained adverse impact of the steep tariffs on India’s merchandise exports. Besides, the impact of the latest salvo on the service exports front, via the Halting International Relocation of Employment (HIRE) Act on outsourcing, remains uncertain at the current juncture.

The outlook for domestic private consumption for H2 FY26 has undoubtedly been brightened by the GST rationalization. We aver that a large part of the gains to consumers from lower GST incidence would be spent on additional goods and services or uptrading to premium options.

Given the earlier-than-expected implementation of the GST cuts at the start of the consumption-heavy festive period, the moderate revenue likely to be foregone in H2 of the ongoing fiscal, and the stronger-than-expected Q1 FY26 GDP print, Icra has revised its FY26 GDP growth forecast from 6.0% to 6.5%, in line with the MPC’s extant projection. Given the risks that linger from persisting uncertainty related to US tariffs on currently exempted goods and services, potential job losses in export-oriented sectors, and a continued deferment of big-ticket private capex, the MPC may choose to refrain from sharply raising its FY26 growth forecast.

While the average CPI inflation for FY26 is likely to print around 2.6%, and October 2025 may mark a fresh low, the subsequent trajectory remains upward sloping. Moreover, the latest downward revision in the CPI inflation forecast for FY2026 is entirely tax-cut driven, and will be associated with higher demand, not driven by the weak demand in the economy. This suggests that a status quo for the repo rate may be the appropriate outcome in the October 2025 policy review, in what is likely to be a rather close call.

Aditi Nayar is chief economist, head-Research & Outreach, at ICRA.