Rate cuts are done. Liquidity is now the real challenge for RBI

The MPC is focused on growth and inflation, both of which are rebounding. Our growth nowcasting model, which tracks 40 high-frequency indicators, shows economic momentum strengthened to around 7% in the December quarter, which is 30bps higher than the model’s estimate for the September quarter. Domestic demand has firmed—albeit unevenly—with improvements across vehicle sales, industrial production and credit.

Growth is expected to be stable, though goods exports are challenged by US tariffs. Free-trade deals and a weaker rupee should aid exporter earnings amid risks. Slower fiscal consolidation will keep growth steady in FY27, supported by vibrant central and state capex that bode well for the medium-term growth prospects.

Overall, GDP growth in FY27 is expected in the 6.5–7% range. The RBI will also likely maintain its GDP forecasts ahead of the new GDP data, which will be released at the end of February with a revised base year and methodology.

Meanwhile, inflation is rebounding from unusually subdued levels as favourable base effects fade. The December MPC meeting followed a downside surprise in CPI inflation, which created space for a rate cut. However, inflation for the December quarter averaged 30bps above the RBI’s projection.

Having already used that window, the MPC will now focus on inflation’s forward profile. For January, inflation likely trended around 2.5%, in line with the RBI’s expectations.

However, like GDP, there is uncertainty on where inflation will be in the revamped CPI series, which will be released on 12 February. Under the current series, at least, headline inflation is expected to cross 4% in the second half of 2026, but core inflation could be weaker.

Outlook comfortable

In short, the growth-inflation outlook remains comfortable for a forward-looking MPC, uncertainty with respect to new data series notwithstanding.

The committee can pause further rate cuts while maintaining a neutral stance. The communication will likely stay growth-supportive and emphasize readiness to respond to any downside risks, especially those linked to US tariffs.

The greater challenge now lies with the RBI. Despite a meaningful easing cycle, transmission remains weak due to tight banking liquidity. The benchmark 10-year bond yield is higher than it was at the start of the rate-cutting cycle and faces upward pressure. Since the last MPC meeting, the weighted average call rate has averaged above the repo rate, and certificate-of-deposit rates have risen in response to money-market tightness.

To keep monetary conditions supportive of growth, the RBI must keep borrowing costs in check even if it cannot push them down decisively while growth and inflation are rebounding. Encouragingly, the central bank has embarked upon durable and temporary liquidity infusions, but more may be needed. This will be a crucial focus in the upcoming policy meeting.

To be sure, India’s liquidity issue does not stem from inadequate base-money creation. Base money is the foundation of all money in the economy – it is the cash people hold plus the reserves that banks keep with the RBI.

Behind the crunch

The RBI recently highlighted in its monthly bulletin that cash reserve ratio-adjusted base money growth stands near 9% year on year, roughly matching nominal GDP growth, in line with the historical norm. The tightness emerges within the banking system, likely due to three factors.

First, currency in circulation has surged unexpectedly to 10.7% y-o-y, the highest since early 2022. The rise in currency leakage began in mid-2024, consistent with improving rural demand and a wave of state elections in 2025. The precise drivers of currency leakage are hard to pinpoint, but the resultant liquidity drain is significant and must be replenished.

Second, RBI’s forex intervention has tightened domestic onshore liquidity. As the rupee declined sharply, the central bank sold US dollars. At times, this intervention was heavy-handed to deter speculative positioning. Given ongoing depreciation risks—reflecting strong corporate hedging demand and equity outflows—the RBI will need to sterilize its future forex interventions through durable liquidity injections.

Third, the banking system’s incremental credit-deposit ratio is likely to rise. Credit growth has improved, but deposit growth has not strictly kept pace. This has created persistent upward pressure on interest rates amid a constrained liquidity pool. Banks have little choice but to bid up deposits or rely more heavily on other costlier avenues, pushing up rates elsewhere, too.

To sum up, current economic data suggest that a few quarters down the line, growth is likely to remain near potential and inflation close to target. There is thus no need to lower the policy rate further and erode India’s real yield advantage.

The more urgent task is to ensure that past rate cuts are transmitted effectively, which requires the RBI to provide additional liquidity and anchor rates in line with the policy rate and stance.

Dhiraj Nim is economist, ANZ Research. Views are personal.