December Cut for Inflation, a February Cut for Growth

The Monetary Policy Committee’s December rate cut marked a decisive shift in tone. The central bank acknowledged that disinflation had broadened and that underlying price pressures had eased more than headline numbers suggested. Excluding gold, core inflation had slowed to 2.6% in October, and the Reserve Bank of India estimated that precious metals alone had added about 50 basis points to headline inflation. The committee lowered its forecasts for inflation in 2025–26 and the first half of 2026–27 by more than markets had expected, reinforcing the argument that low inflation was neither a one-off nor a transient surprise.

The broader signal, though, ran deeper. The December move was driven by the RBI’s growing conviction that inflation had softened in a more durable manner, supported by back-to-back quarters of sub-target headline prints and commodity trends that offer a strong buffer for the months ahead. With crude oil likely to drift towards $50 in the first half of next year and gold expected to consolidate between $4,000 and $4,500 levels, the committee effectively acknowledged that the disinflation cycle is no longer transitory.

Yet the next leg of the story may turn on growth rather than prices. Fiscal space is tightening, household demand remains soft, and forward-looking indicators point to a loss of momentum. If these pressures deepen, the February meeting may need to lean more heavily on monetary support, shifting the narrative from an inflation-led cut in December to a growth-sensitive response early in the new year.

Headline inflation in the July–September quarter of 2025–26 stood at 1.7% and is likely to remain close to 0.6% in the October–December quarter. That puts inflation below the lower bound of the tolerance band for two consecutive quarters. A low-for-longer rate environment appears more plausible than it did a few months ago.

Many traders had feared that pressure on the rupee might stay the committee’s hand. Yet the currency’s recent depreciation looks more like a conscious policy choice than an accidental by-product. A weaker rupee helps reflate subdued inflation, supports exports, and makes domestic assets more attractive to foreign capital. These objectives align neatly with the committee’s evolving priorities.

If policy easing is to transmit meaningfully, liquidity must do more of the lifting. The combination of a ₹1 trillion open market purchase and a $5 billion foreign-exchange swap injected roughly ₹1.45 trillion of durable liquidity into the system. Even so, much more may be required in the final quarter of 2025–26. The Governor noted that system liquidity should ideally remain between 0.6% and 1% of net demand and time liabilities. On a 1% threshold, the central bank may need to infuse close to ₹2 trillion of durable liquidity in the March quarter once currency leakage, government bond maturities, and modest balance of payments support are accounted for.

Reflating Economy
India’s macro backdrop leaves little room for complacency. Domestic savings continue to fund foreign capital outflows. Money supply growth remains out of step with nominal GDP. Without a revival in nominal activity, debt dynamics, tax revenues, and corporate earnings all risk slipping. Household consumption needs a lift to give firms the confidence to commit to new investment cycles. A certain level of core inflation is essential for an emerging economy where wage growth, pricing power, and government revenues depend on firmer demand. India has not yet reached productivity levels where near-zero headline inflation can be celebrated. Current readings reflect muted aggregate demand and weak real wages. Tax reforms through income tax reductions and lower goods and services tax rates would ease pressure on stretched household balance sheets at a critical juncture.

Seen in this light, the December cut was as much about reflating the economy as acknowledging a favourable inflation backdrop. Lower policy rates raise disposable income for households and ease financing conditions for corporates that support private capital expenditure. The liquidity measures announced alongside the cut are equally central to the strategy because reserve money creation remains vital when incremental credit-deposit ratios are elevated. The Governor’s distinction between tools for durable liquidity and those for frictional liquidity management suggests more open market purchases are likely, particularly in the five- to ten-year segment of the government bond curve where early operations have been concentrated.

Growth concerns are resurfacing just as the inflation narrative turns benign. The Governor’s own footnotes pointed to slowing purchasing managers’ indices and weaker industrial output, a rare acknowledgement amid otherwise upbeat commentary. The fiscal backdrop in the second half of 2025–26 is tightening. Tax revenues have grown only 4% so far against a budget estimate of 11%, which implies a likely reduction in central government spending. States may curtail capital expenditure as they contend with competing welfare commitments. The full impact of 50% US tariffs on Indian exports may emerge only in the second half of the year because outbound shipments in the first half were inflated by front-loading. Even the recent rise in goods and services tax collections may fade as urban household incomes remain under strain.

If no US trade deal materialises before the next decision, the February meeting becomes a genuinely live one. A tight fiscal stance cannot bear the burden of supporting growth on its own, particularly when disinflation looks entrenched. December delivered a dovish twenty-five-basis-point cut and the committee may not hesitate to follow through if growth risks intensify. Domestic interest rates appear set for a lower-for-longer trajectory.

Bond traders might like the five- to six-year segment where the risk-reward profile remains attractive considering both carry and roll. State development loan spreads may stay elevated given the heavy supply expected in the March quarter. Duration beyond ten years may offer sharp rallies but could struggle to sustain them amid global long-end vulnerability and persistent state issuance. Ten-year yields may test 6.35% by mid-January as news flow picks up on possible inclusion in the Bloomberg Global Aggregate Index. Any rally may stall shortly before the Union Budget as investors pare risk.

For now, the doves rest their case with due caution. A dense run of domestic data through January and February will determine whether the terminal rate in 2026–27 settles near 5.25% or whether the economy demands even more policy support.