RBI’s Rate-Cut Problem Is Not the Cut — It Is the Plumbing

India’s monetary policy problem is no longer about the direction of interest rates. It is about whether the central bank’s signals are reaching the market at all. By late 2025, the widening disconnect between the repo rate, overnight funding costs, and long-term bond yields has exposed a deeper fault line in the transmission mechanism, one that rate cuts alone cannot repair.

Under normal conditions, monetary transmission works through a simple hierarchy. The policy repo rate sets the institutional benchmark. The weighted average call rate reflects the operational reality of liquidity. Government bond yields then embed expectations of future overnight rates, inflation, and fiscal risk. When this chain holds, a repo rate cut pulls down overnight rates, which in turn drags the yield curve lower. That logic has clearly broken down.

The December 5, 2025, repo rate cut to 5.25% should, in theory, have eased financial conditions. Instead, the weighted average call rate tightened to around 5.43%, hugging the upper end of the liquidity corridor. The bond market took its cue from this reality rather than from the RBI’s signal. By mid-January, one-year overnight indexed swap rates had climbed to about 5.56%, indicating that professional traders were pricing in persistently tight funding conditions despite the policy easing.

This divergence matters because the overnight rate is not just another money-market statistic. It is the operating target of monetary policy, the point where liquidity frictions, fiscal flows, tax outflows, and foreign exchange intervention collide in real time. When the call rate drifts away from the policy corridor, the bond market stops listening to the central bank and starts following the plumbing.

The consequences are visible along the yield curve.

Conceptually, a 10-year government bond yield can be viewed as the compounded expectation of roughly 3,650 overnight funding decisions plus a term premium. When overnight rates stay elevated, long-term yields resist policy easing, regardless of how many times the repo rate is adjusted. In 2019, nearly 88% of policy rate cuts passed through to bond yields. In the current cycle, barely a quarter has.

The immediate cause is not a lack of liquidity in aggregate but its fragmentation. Large banks, flush with stable current account and savings account balances, have parked close to ₹1.25 trillion in the standing deposit facility at 5.00% rather than lend to peers facing sudden funding pressure. Liquidity was technically in surplus but operationally trapped where it was least useful.

External pressures compounded the problem. As the rupee slid past ₹90 to the dollar, foreign portfolio investors withdrew more than $1 billion from the debt market in December alone. Outflows through the fully accessible route accelerated sharply, tightening domestic liquidity even as headline surplus numbers appeared comfortable. At the same time, the RBI’s foreign exchange interventions to smooth currency volatility mechanically drained rupee liquidity from the system.

The central bank attempted to offset this erosion with a dual-track approach. Daily liquidity was absorbed through the standing deposit facility to contain volatility, while durable liquidity was injected through open market operations and foreign exchange swaps exceeding ₹1 trillion. Yet the effort resembled weightlifting against a structural headwind. A looming ₹5 trillion supply of state government debt and a surge in gold imports added to the strain, keeping term premia elevated.

The result is a market that is effectively betting against the RBI’s easing signal. With the 10-year government bond yield stuck near 6.7% and short-end swap rates elevated, investors are demanding a 65–70 basis point risk premium to compensate for funding uncertainty and supply risk. This is less a vote on inflation than a judgment on liquidity durability.

This episode reveals a shift in the binding constraint on monetary policy. When structural drains and external shocks intensify, signalling through rate cuts becomes a white-collar exercise that markets politely ignore. Transmission now depends on blue-collar liquidity management, the unglamorous work of keeping the overnight rate anchored through sustained and credible injections.

This reality argues for caution in the February policy cycle. With inflation showing signs of bottoming out in December after a sharp November decline, an aggressive follow-up rate cut risks adding noise without restoring transmission. A neutral stance, paired with forceful liquidity operations, would better align policy intent with market behaviour.

That means prioritising durable tools. Larger and more frequent open market purchases, longer-tenor foreign exchange swaps and a willingness to reshape government borrowing towards shorter-term bills could help repair the overnight funding channel. Temporary band-aids are unlikely to suffice when the system is grappling with persistent capital leakage.

India’s yield curve remains the nervous system of its financial stability. Until the RBI restores the integrity of the overnight rate link, policy signals will continue to lose potency in transit. The lesson from 2025-26 is stark: when plumbing breaks, no amount of signalling can keep the water flowing.