The RBI’s Strategic Pause, Conserving Ammunition in a Landscape of Cautious Optimism and Unresolved Risks

The RBI’s Strategic Pause, Conserving Ammunition in a Landscape of Cautious Optimism and Unresolved Risks

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), in its February meeting, delivered a decision that was both predictable and profound. As anticipated, the committee voted unanimously to hold the repo rate steady, maintaining a neutral stance. This status quo, following a cumulative 125 basis points (bps) rate cut in 2025, is far from a passive or static position. It represents a calculated and strategic pause—a conscious decision by the central bank to conserve its limited policy ammunition in the face of a complex economic landscape marked by improving growth tailwinds, comfortable but watch-worthy inflation, and significant, unresolved fiscal and external pressures. This pause is not an endpoint, but a vigilant position from which the RBI can observe, assess, and act only when the data compels it to do so.

The Rationale for Restraint: Growth on the Mend, Inflation at Bay

The RBI’s decision to hold rates is firmly anchored in two stabilizing pillars: a brightening growth outlook and the continued benign trajectory of inflation.

• Revitalized Growth Momentum: The Indian economy is displaying robust health, with advance estimates projecting a GDP growth of 7.4% for FY26. This momentum is expected to receive a significant, albeit moderate, external boost from the recently concluded India-US trade deal. As the article notes, the earlier imposition of punitive US tariffs had begun to bite, causing a contraction in key export segments like gems & jewellery, textiles, and chemicals in the latter part of 2025. The lowering of these tariffs provides a crucial reprieve. A preliminary analysis suggests this could add approximately 0.2% to GDP growth, potentially lifting FY27 projections to around 7.2%. Furthermore, the trade deals with both the US and the European Union are expected to improve investor sentiment and attract greater capital flows, reinforcing the growth cycle. The RBI itself has mirrored this optimism by revising its first-half FY27 growth projection upwards by 20 bps.

• Comfortable Inflationary Backdrop: On the price stability front, the RBI has room to breathe. Inflation is estimated at a comfortable ~3.2% for Q4 FY26, with core inflation (excluding volatile food and fuel, and the recent impact of gold prices) at a low ~2.6%. Assuming a normal monsoon—a perennial caveat in Indian macroeconomics—inflation is projected to remain around the 4% target in FY27. This creates a window where the central bank is not compelled to act against surging prices, allowing it to focus on supporting growth.

This “Goldilocks” scenario—growth not too cold, inflation not too hot—provides the ideal justification for a pause. It allows previous rate cuts to fully transmit through the economy while giving the RBI time to assess the impact of new variables, most notably the impending revision of the GDP and CPI series, which could fundamentally alter the baseline understanding of the economy’s potential and inflationary pressures.

The Persistent Conundrum: The Disconnect Between Policy Rate and Bond Yields

Beneath the surface of this macroeconomic stability lies a more troubling and persistent tension: the breakdown of monetary policy transmission, particularly in the government bond market. Despite the RBI’s 125 bps rate cuts in 2025, the yield on the 10-year government security (G-Sec) has risen by 45 bps in the last eight months. This has pushed the spread between the 10-year yield and the repo rate to a worrisome 150 bps, a level indicating significant market stress and a disconnect from the RBI’s accommodative intent.

The root cause of this is unequivocally fiscal. The central government’s large gross borrowing program for FY27, coupled with aggressive borrowing by state governments, has created a massive supply glut of bonds in the market. High demand for capital from the government is crowding out private investment and pushing yields upwards, irrespective of what the RBI does with the policy rate. The spread on 10-year state government bonds over central G-Secs has also widened dramatically, from 35 bps to 70 bps, reflecting heightened credit risk perceptions amid stretched state finances.

This scenario puts the RBI in a bind. As the government’s debt manager, it must ensure borrowing costs do not spiral out of control, threatening fiscal stability. As the monetary authority, it needs yields to reflect its policy stance to ensure banks lower lending rates. To bridge this gap, the RBI has been, and will likely continue, relying on liquidity management operations like Open Market Operations (OMO purchases) to inject durable liquidity and artificially create demand for bonds, thereby containing yields. The status quo on the repo rate is thus accompanied by an ongoing, active battle on the liquidity front.

The Liquidity Tightrope: From Surplus to Scarcity and the Forex Factor

The management of systemic liquidity has been another delicate act. After maintaining a surplus of around ₹2 trillion on average in the first eight months of FY26, liquidity tightened to an average of ₹0.7 trillion in the last two months. One key reason for this tightening has been the RBI’s intervention in the foreign exchange market.

To prevent excessive volatility or depreciation of the Indian rupee, the RBI has likely been selling US dollars from its reserves. This dollar sale sucks out an equivalent amount of rupee liquidity from the banking system. However, with the US trade deal signed, there is an expectation of improved capital inflows and currency stability, which could reduce the need for such aggressive forex intervention. This, in turn, would ease one source of liquidity tightness. The RBI’s promise to ensure “ample liquidity” suggests it stands ready to use other tools—repos, targeted long-term repos, or OMOs—to keep the system’s liquidity comfortable and short-term rates aligned with the repo rate.

Global Uncertainties: The Uncontrollable Variable

While domestic conditions provide rationale for a pause, the RBI’s decision is also a hedge against a volatile and uncertain global environment. Geopolitical tensions, the trajectory of commodity prices (especially oil), and the monetary policy path of major central banks, particularly the US Federal Reserve, remain significant wild cards. A sudden flare-up in global risk aversion could trigger capital outflows from emerging markets like India, putting downward pressure on the rupee and upward pressure on inflation. By holding rates and preserving its policy space, the RBI maintains maximum flexibility to respond to such external shocks—whether it requires injecting liquidity to stabilize markets or, in a more extreme scenario, using rate cuts to counter a growth shock.

The Path Forward: A Prolonged Pause with a Liquidity Backstop

The article’s conclusion, that the RBI is likely to maintain the status quo on policy rates for the foreseeable future, is well-founded. The central bank is in a classic “wait-and-watch” mode. It will monitor:

1. The actual impact of the trade deals on export growth and capital flows.

2. The evolution of inflation post the monsoon and the new CPI series.

3. The government’s borrowing calendar and its effect on bond yields.

4. Global financial conditions and commodity price movements.

The focus will shift almost entirely to the operational aspects of monetary policy: meticulous liquidity management to ensure credit flow to the productive sectors, and strategic interventions in the bond market to prevent a destabilizing rise in government borrowing costs. The RBI has, in effect, signaled that the heavy lifting for growth in the near term will come from fiscal policy (government spending and trade deals) and a resurgence in private investment, while it stands guard against inflation and financial instability.

Conclusion: Prudence as the New Policy

The RBI’s February policy is a testament to the virtue of strategic prudence. In a world quick to demand action, the central bank has chosen inaction, recognizing that sometimes the most powerful tool is unused ammunition. By pausing, it acknowledges the limits of monetary policy in the face of a fiscal-led yield crisis. By committing to liquidity support, it ensures the financial system remains functional. And by highlighting global risks, it prepares the public for potential turbulence ahead.

This is not a central bank on the sidelines; it is a central bank on high alert, having moved its primary lever and now meticulously managing the complex plumbing of the financial system. The message is clear: the growth recovery is welcomed but not yet fully secured, inflationary pressures are dormant but not dead, and the greatest immediate risks are of fiscal origin. In this environment, conservation of firepower is not caution—it is the highest form of strategic wisdom.

Q&A: Understanding the RBI’s Strategic Pause

Q1: Why did the RBI choose to pause interest rates after cutting them by 125 bps in 2025, even though inflation is under control?

A1: The pause is a strategic decision based on a multi-factor assessment, not just inflation. Key reasons include:

• Growth is Self-Sustaining: With GDP growth estimated at 7.4% for FY26 and a boost expected from the US trade deal, the immediate need for further stimulus has diminished. The economy is showing internal momentum.

• To Assess Lagged Effects: Rate cuts work with a lag. The RBI is pausing to allow the full impact of the 125 bps cuts from 2025 to transmit through the economy before considering more action.

• Preserving Ammunition: With global uncertainties high, the RBI wants to conserve its policy space (ammunition) for potential future shocks. Cutting rates now would leave it with less room to maneuver if a crisis hits later.

• Addressing the Real Problem: The main constraint for lower borrowing costs isn’t the policy rate, but high government bond yields driven by fiscal borrowing. The RBI needs to tackle this through liquidity operations (like OMOs), not further repo rate cuts.

Q2: What is the “transmission problem” mentioned regarding G-Sec yields, and why is it happening?

A2: The transmission problem refers to the failure of the RBI’s policy rate cuts to lead to a corresponding decline in longer-term interest rates in the economy, specifically the 10-year government bond (G-Sec) yield. Instead of falling, these yields have risen by 45 bps.

This is happening due to a classic supply-demand imbalance in the bond market:

• Massive Supply: Both the central and state governments have very large borrowing programs (high fiscal deficits) to finance their spending. This floods the market with new bonds.

• Limited Demand: The demand from banks, insurance companies, and foreign investors is not sufficient to absorb this huge supply without demanding a higher interest rate (yield).

• Crowding Out: The government’s insatiable demand for capital is crowding out other borrowers and pushing up the price of credit for everyone. The RBI’s repo rate cuts are being overwhelmed by this fiscal reality.

Q3: How does the India-US trade deal influence the RBI’s policy calculus, both on rates and liquidity?

A3: The trade deal influences the RBI’s thinking in two significant ways:

1. Growth and Export Outlook: The lowering of US tariffs provides a direct boost to Indian exporters who were facing contraction. This improves the growth outlook, reducing the urgency for further monetary stimulus. The article estimates a 0.2% GDP boost, giving the RBI more confidence to pause.

2. Forex Market and Liquidity: The deal is expected to improve investor sentiment and attract foreign capital flows into India. This supports the Indian rupee (INR). A stronger rupee expectation means the RBI may not need to sell US dollars aggressively to defend the currency. Since selling dollars sucks out rupee liquidity from the banking system, less intervention means tighter domestic liquidity conditions can ease. The RBI itself cited this as a factor that could reduce future liquidity tightness.

Q4: What is the significance of the upcoming new GDP and CPI series for monetary policy?

A4: The revision of the GDP and Consumer Price Index (CPI) series is a major statistical event that can reshape the RBI’s understanding of the economy.

• New GDP Series (Base Year Change): This will revise historical and current growth rates. If the new series shows the economy has been growing faster than previously thought, the output gap (the difference between actual and potential GDP) might be smaller. This could imply less spare capacity and higher underlying inflationary pressure, arguing for a less accommodative policy stance.

• New CPI Series: This will update the basket of goods and their weights to reflect changing consumption patterns. It could change the recorded inflation trajectory. A revised CPI might show a structurally higher or lower inflation path, directly impacting the RBI’s ability to meet its 4% target.

The RBI is pausing, in part, to await this crucial data reset before making any new directional commitments.

Q5: If not a rate cut, what are the main tools the RBI will use in the coming months to manage the economy?

A5: With rates on hold, the RBI’s toolkit shifts to liquidity and market management operations:

• Open Market Operations (OMO Purchases): The most likely tool. The RBI will buy government bonds from the market to inject permanent liquidity and create demand, thereby helping to anchor and lower G-Sec yields.

• Forex Swap Operations: To manage rupee liquidity without directly impacting forex reserves, using instruments like dollar/rupee buy-sell swaps.

• Targeted Long-Term Repo Operations (TLTROs): Providing cheap, long-term funds to banks specifically for lending to certain sectors.

• Assuring “Ample Liquidity”: Through daily fine-tuning operations (repo/reverse repo) to ensure the banking system has enough cash to meet credit demand and keep short-term rates near the repo rate.
  The focus is squarely on ensuring smooth government borrowing and supporting credit growth, using balance sheet tools rather than the policy rate tool.