Rate cut signals RBI’s pivot to growth amid sharp inflation slowdown

It does not happen very often that a central bank goes into its monetary policy meeting having overachieved on both its targets. With gross domestic product (GDP) growth averaging 8% (above the 7% potential level) and inflation based on consumer price index (CPI) averaging 2.2% (below the target of 4%) in 1HFY26, the Reserve Bank of India (RBI) had ample policy room to meet its dual mandate in 1HFY26. But given the primacy of inflation in its mandate, the RBI did well to reduce the repo rate by 25 basis points (bps) to 5.25%. The central bank also took steps to support monetary policy transmission by announcing open market operations of ₹1 trillion, dollar buy-sell swaps ($5 billion) and promised to provide adequate liquidity going forward.

The repo rate reduction will likely boost growth, just when it's feared to soften in 2HFY26 due to US tariff-related headwinds and an expected slowdown in government spending. The monetary policy support via rate cuts and easy liquidity complements the measures already taken by the government in the form of goods and services tax (GST) cuts. The depreciation of the rupee also adds to this reflationary impetus and all policy levers are now fully geared towards supporting growth.

The pressure to cut rates also stemmed from CPI inflation slipping below the lower bound of 2% in Q2FY26, even though the RBI’s mandate is to keep inflation within the 2–6% band. The RBI has lowered its inflation estimate not only for this year to 2% (from 2.6% earlier), but also for H1FY27 to 4%. What is driving such a sharp undershoot of inflation? First, food inflation is very benign. This year, food prices have fallen by 1.1% during April-October, led by an 18.5% contraction in vegetable prices. Given two back-to-back good monsoons, the outlook is also favourable for the upcoming rabi crop. Secondly, core inflation too is around the target of 4%, and if precious metals are excluded, it too is below the target. Given benign outlook for food and core excluding precious metals, inflation trajectory for next year seems to be closer to target as of now.

While inflation estimates have been pruned, growth estimates have been revised higher. Growth in H1FY26 has surprised positively at 8% and the RBI has revised its growth forecast for H2FY26 higher as well to 6.7% from 6.3% earlier. This upward revision is led by fiscal and monetary stimuli, driving demand higher. Growth estimate for H1FY27 too has been revised higher to 6.8% from 6.5% earlier. For FY26, the RBI now expects growth at 7.3%, which is a tad lower than our estimate of 7.5%. The slowdown in coming quarters is possibly because of weaker exports and the waning of front-loaded government spending.

The recent depreciation and volatility in the currency had cast doubts about the possibility of a rate cut in this policy. However, the RBI governor clarified that the MPC mostly looks at growth and inflation dynamics and to the extent rupee depreciation impacts both inflation and growth, it has an impact on the policy outcome. Normally, a weaker rupee helps in reflating the economy via higher imported inflation and improving export competitiveness. Given flat exports and significant undershoot of inflation this year, a weaker currency should help. In addition, the volatility in the currency is on account of moderation in capital inflows into the country and not because of a higher current account deficit, which would require a course correction. Notably, current account deficit is expected to remain benign, which gives RBI sufficient room on the monetary policy front to ease interest rates.

The RBI governor emphasized that the focus has shifted to transmission for which RBI announced open market operations and 3-year US dollar buy-sell swaps. We expect the RBI to do further durable liquidity operations of ₹1.5 trillion in the January-March quarter to facilitate further transmission.

What does all this mean for bond yields? Given that we are pretty much at the end of the rate-cutting cycle, unless inflation surprises further to the downside, a steepening of the yield curve is expected, and that is what has happened after today’s rate cut. The longer end of the curve responds more to demand-supply dynamics than to the gyrations in policy rates. Hence, the yield on 10-year bond is expected to range between 6.35% and 6.55% (6.5% currently). The range could shift leftwards if Indian bonds get included in the Bloomberg index, for which an announcement is expected in January.

Finally, is this the end of the rate-cutting cycle or is there room for further cuts. From a real rate standpoint, given inflation will be at 4% in H1FY27, the real rate is now around 1.3%, which is at the lower end of RBI’s neutral rate range of 1.4-1.9%. It is therefore fair to assume that we are near the bottom in terms of policy rates. The RBI would probably focus on the transmission of the rate cut before deciding on further course of action.

Shailendra Jhingan is the head of treasury, ICICI Bank.