Risk revision: We can expect RBI to walk its accommodative talk

Policy decision-making becomes increasingly difficult amid heightened uncertainty, especially as economies with current account deficits need to balance the contagion risks of capital outflows and currency depreciation. However, we see some key trends emerging over the next few months, which will create room for the MPC to continue on its accommodative policy path.

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First, escalating trade tensions and severe uncertainty are providing more and more certainty of sharp downside risks to global growth and upside risks to inflation. While already-elevated and sticky core inflation in the US may constrain the Federal Reserve on the extent of its monetary easing, the deteriorating growth outlook may prompt it into action to soften the severity of a slowdown. As high inflation begins to seep into the US economy, the ripple effects will be felt in corporate profitability and a slide in consumer demand.

Second, there is another key outcome of escalating trade tensions—of the deflationary spiral spinning over to the rest of the world from excess supply in China, Vietnam, Mexico, Japan and other key exporting countries, which will need to diversify exports away from the US. On one hand, this could offset tariff-related global inflationary pressures, but the risk of deflationary pressures in Asia, specifically, could also prompt additional protectionist policies across nations to cushion their domestic sectors. Needless to say, the future is appearing very complex as the spillover effects of US tariffs reverberate across markets.

Third, as the MPC attempts to evaluate the scope of contagion risks, there exists a clear downtrend in domestic growth, as indicated by high-frequency indicators. While India’s rural consumption has been holding steady, urban demand is tepid. Tariff-led uncertainty is expected to further delay a revival in the private-capital-expenditure cycle and weigh on corporate earnings amid supply disruption risks and pressure on margins as they consider absorbing partly the tariff-led price hike to retain market share in the US.

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Our 2025-26 GDP estimate of 6.5% has a downside risk of 40-50 basis points as global risks unfold. While the pace of fiscal consolidation is expected to be slower in 2025-26 compared to last year, the overall headroom to address softness in growth remains limited, as slower growth could weigh on tax collections. That said, we don’t expect fiscal slippage, given our expectation of some upside to the Reserve Bank of India’s (RBI’s) dividend estimate over the budgeted amount of ₹2.1 trillion.

Fourth, the country’s inflation outlook remains benign, promising to stay around RBI’s 4% target in 2025-26 if weather conditions stay favourable. Early indications suggest a normal monsoon as neutral El Niño conditions are likely to prevail this year.

Further, RBI has been walking the accommodative talk by extending liquidity easing measures aggressively. This suggests a strong intent to ensure smooth monetary transmission as it continues on its policy rate easing path. India’s central bank has infused durable liquidity of about ₹6.5 trillion by way of a cut in the cash reserve ratio, bond purchases via open market operations (OMO) and foreign currency swaps.

Besides, RBI has transitioned to overnight variable repo rate auctions to ease frictional liquidity tightness. With the recent strengthening trend observed in the rupee, we see room for RBI to step in to cap its gains, thereby further adding to easy liquidity conditions. This, however, could help offset the heavy short-forward book of RBI worth $89 billion, while also limiting the scope for additional liquidity-easing measures through OMO purchases that it is currently resorting to.

With liquidity conditions suitably comfortable and weighted average overnight rates settling far below the repo rate, we expect a 25-basis-points rate cut to 6% in the monetary policy decision due on Wednesday and see high probability of a change in stance to ‘accommodative.’ While the repo rate cut is expected to be a consensus view among MPC members, a change in stance may see dissent, given the global volatility.

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Going ahead, we see room for the repo rate to fall to 5-5.25%, depending on the extent to which global risks weigh on domestic growth. Notably, the increasing probability of a global recessionary environment has set off a clamour for front-loaded and heavy rate cuts in each policy review by RBI. That said, while a deeper rate-cut cycle will be necessary to support growth, immediate aggressive rate cuts may not be the need of the hour. Policy support will need to be nimble but cautious to avert financial instability, given the magnitude of uncertainty arising from unknowns.

Besides, we await some guidance on timelines and the details of the central bank’s new liquidity framework. Clarity is awaited on the continuation of the weighted average call rate as the MPC’s operating target, re-introduction of on-tap fixed repo operations and any other fine-tuning measures designed to ease liquidity management.

The author is chief economist, Kotak Mahindra Bank.