Monetary Policy at a Crossroads, Why the RBI Must Embrace the Wait and Watch Mantra

Monetary Policy at a Crossroads, Why the RBI Must Embrace the Wait and Watch Mantra

As the Reserve Bank of India’s Monetary Policy Committee (MPC) convenes for its first meeting of the financial year, the economic landscape presents a complex tapestry of subdued inflation, resilient growth, and simmering external risks. The consensus expectation, strongly argued in the analysis, is for a status quo—a continuation of the repo rate at 5.25%. This anticipated pause is not a sign of indecision but a strategically prudent stance of “wait and watch.” It reflects a sophisticated balancing act where the central bank must weigh the theoretical space for a final rate cut against a cocktail of more pressing concerns: ensuring effective policy transmission, managing the external account, and preserving precious policy ammunition in an increasingly volatile global environment.

This current affair analysis delves into the multi-faceted rationale behind this cautious approach. It argues that the RBI’s optimal path forward lies not in a reflexive, incremental rate cut, but in a continued focus on liquidity management, vigilant monitoring of new inflation data, and safeguarding macroeconomic stability. The era of straightforward cyclical easing is over; the MPC now enters a phase of nuanced calibration where holding steady is the most potent form of action.

Part 1: The Inflation Conundrum: A Statistical Reprieve vs. Underlying Reality

The most tantalizing argument for a potential rate cut rests on an imminent statistical event: the base year revision of the Consumer Price Index (CPI). The Ministry of Statistics and Programme Implementation is set to release a new CPI series with a revised base year of 2024. Preliminary analyses, including the one cited, suggest this methodological shift could mechanically lower the measured headline inflation rate for FY27 by 30-40 basis points (bps). If current forecasts hover around 4.1%, this revision could push inflation closer to the midpoint of the RBI’s 2-6% target band, ostensibly creating room for one final easing move.

However, this is precisely where prudence must override temptation. The MPC would be ill-advised to act on projections derived from applying new weights to old data. The revised series incorporates expanded coverage of items and consumption patterns, methodological refinements, and possibly new data sources. The full impact on the inflation trajectory remains an unknown until the new series is live and has generated several months of data. To cut rates based on assumed disinflation would be to make policy on a statistical artifact, not economic reality. The RBI’s credibility, painstakingly built over years of inflation targeting, hinges on responding to durable trends, not provisional recalculations. Therefore, the logical course is to “await full clarity on the FY27 inflation trajectory in the new series”—a process that will take at least one full quarter post-release.

Furthermore, the “availability of space to cut rates does not warrant a need to use it just as of now.” Inflation, while within target, is not decisively vanquished. Core inflation (excluding volatile food and fuel) remains sticky. Geopolitical tensions and supply chain fragmentation pose persistent upside risks to commodity prices. A preemptive cut based on optimistic data revisions could leave the RBI flat-footed if these risks materialize.

Part 2: The Transmission Trap: Why Liquidity Trumps Another Rate Cut

The ultimate objective of monetary easing is to lower the cost of borrowing across the economy—for businesses investing in capacity and for consumers financing homes and vehicles. This process, known as monetary policy transmission, has been incomplete and uneven in the current cycle. While the repo rate has been reduced, market interest rates, particularly government bond yields, have not fallen in lockstep. The 10-year bond yield, a benchmark for corporate borrowing and long-term loans, has remained elevated or even drifted upwards.

The analysis identifies the core issue: “better transmission… can work more effectively with a focus on adequate liquidity provision.” The recent past has seen periods of liquidity deficit in the banking system, which pushes short-term money market rates above the repo rate, effectively tightening conditions even as the policy rate signals ease. The government’s larger-than-expected gross market borrowing program for FY27 further exacerbates this by flooding the market with bond supply, putting upward pressure on yields.

In this context, another symbolic 25-basis-point cut in the repo rate is likely to have a “limited impact.” If financial markets perceive that this cut represents the end of the easing cycle—or worse, that the next move could be a hike due to emerging risks—its effect on long-term yields will be negligible. The market’s focus has shifted from the policy rate to the liquidity and supply-demand dynamics in the bond market.

Therefore, the RBI’s most potent tool for now is not the policy rate lever but its liquidity operations. The central bank has multiple instruments—open market operations (OMOs) to purchase bonds, targeted long-term repo operations, and adjustments to the standing deposit facility—to inject durable liquidity into the system. By ensuring abundant liquidity, the RBI can force short-term rates to align with the repo rate and help contain the rise in long-term bond yields. This “liquidity provision via various tools… will remain a key factor in keeping market rates anchored.” A rate cut without addressing the liquidity deficit would be an empty gesture; addressing the liquidity deficit may obviate the need for a cut altogether.

Part 3: The External Sector: Guarding the Rupee and Building Buffers

India’s monetary policy can no longer be crafted in domestic isolation. In a world of high U.S. interest rates and volatile capital flows, external sector considerations impose critical constraints. The analysis highlights a stark vulnerability: a dramatic plunge in net Foreign Direct Investment (FDI) from a peak of $40 billion in FY20 to a mere $1 billion in FY25. This collapse is attributed to higher global rates, the magnetic pull of AI-focused investment in developed markets, and a slower-than-expected revival in domestic private capex.

While India’s foreign exchange reserves remain robust (covering about 10 months of imports), the decline in durable FDI inflows weakens the fundamental balance of payments support for the rupee. The RBI has wisely allowed the rupee to act as a “shock absorber,” managing volatility without defending a rigid level. However, widening the interest rate differential with the U.S. through a rate cut would further “de-incentivise USD raising” for Indian corporates and could exacerbate portfolio outflows, adding depreciation pressure on the currency.

A weaker rupee, in turn, directly feeds into inflation by increasing the cost of India’s vast imports, from crude oil to electronics. With crude oil prices quietly inching toward $70/barrel and base metal prices facing upside risks, a depreciating currency could swiftly translate into imported inflation, jeopardizing the disinflation process. Thus, maintaining the policy rate “at least takes off additional pressure on the Indian rupee and the import bill.” In an uncertain global environment marked by “geopolitical tensions [and] trade fragmentation,” it is imperative to build and preserve external buffers. A rate cut today would consume policy space that might be desperately needed later to counter an external shock.

Part 4: Growth Dynamics: The End of Cyclical Support and the Need for Structural Reform

The domestic growth argument for a rate cut is also weak. The Indian economy is demonstrating remarkable resilience. GDP growth for FY26 is estimated at a robust 7.5%, and projections for FY27, while moderating, remain strong in the 6.6-7.2% range. The output gap is likely closing, meaning the economy is operating near its potential. In such a scenario, further monetary stimulus is not only unnecessary but could be counterproductive by potentially overheating certain sectors or fueling asset price bubbles.

The analysis correctly notes that “the next push to growth needs to come from the ease and speed of doing business in India rather than relying on counter-cyclical measures like interest rate reductions (which has run its course).” This is a crucial insight. The low-hanging fruit of cyclical rate cuts has been harvested. The binding constraints on India’s growth are now structural: land and labor market rigidities, logistical inefficiencies, and judicial delays. As highlighted, the Economic Survey itself emphasizes the need to “bring down the structural cost of capital,” which is a function of savings rates, financial sector efficiency, and macroeconomic stability—issues beyond the reach of the repo rate alone.

Monetary policy is a blunt tool. It cannot fix structural bottlenecks. Cutting rates in a supply-constrained, high-growth environment risks stoking demand-pull inflation without meaningfully boosting sustainable investment. The RBI’s role now is to provide a stable macroeconomic backdrop—low and predictable inflation, and stable financial conditions—within which the government’s structural reforms and private sector animal spirits can drive the next phase of growth.

Part 5: The Prudent Path: Strategic Patience and Liquidity-First Focus

Given this constellation of factors, the MPC’s most responsible strategy is one of strategic patience. The “wait and watch” mode offers several advantages:

1. Data Dependence: It allows time to assess the true inflation trajectory under the new CPI series and monitor the monsoon’s progress, which is critical for food prices.

2. Enhanced Credibility: It demonstrates that the RBI is not on autopilot but is responding to a complex, real-time assessment of risks.

3. Preservation of Ammunition: It keeps “powder dry” in the form of a 5.25% repo rate. Should a severe external shock or a unexpected domestic slowdown materialize later in FY27, the RBI would have meaningful space to cut rates and provide counter-cyclical support. A cut now would diminish this precious buffer.

4. Focus on Effective Transmission: It enables the central bank to double down on its liquidity management operations, which are currently more critical for influencing actual financing conditions in the economy.

The immediate policy focus, therefore, should unequivocally be on moving the system liquidity from deficit to a modest surplus, using a combination of tools, including bond purchases (OMOs). This will help align market rates with the policy rate, support the government’s borrowing program without excessive yield volatility, and ensure that the existing stance is fully transmitted to the real economy.

Conclusion: Steadiness as Strategy

The upcoming MPC meeting is not about a binary choice between cutting or hiking. It is about affirming a stance of vigilant stability. In a world rife with uncertainty, the greatest contribution a central bank can make to India’s growth story is to ensure macroeconomic stability. This means guarding against premature inflation risks, preventing disruptive currency volatility, and ensuring the financial system has ample liquidity to support credit growth.

By holding the repo rate steady and prioritizing liquidity infusion, the RBI would be sending a powerful message: that it is confident in India’s growth momentum, attentive to latent risks, and committed to fostering stable financial conditions for the long haul. The “wait and watch” approach is not passive; it is an active, disciplined strategy of preserving policy optionality and reinforcing stability—the very foundation upon which India’s ambitious economic aspirations must be built. The time for a final rate cut may yet come, but it is not this week. Prudence dictates that for now, the steady hand on the tiller is the most courageous course of action.

Q&A

Q1: The analysis suggests the new CPI series could lower measured inflation. Why shouldn’t the RBI cut rates based on this expected disinflation?
A1: The RBI should not act on projected disinflation from a statistical revision because the new CPI series is an unknown variable. While re-weighting existing data suggests lower inflation, the revised series includes expanded item coverage, methodological changes, and updated consumption patterns whose full impact is unpredictable. Making a permanent policy decision (a rate cut) based on a provisional, untested data series would risk undermining the central bank’s credibility. The prudent approach is to “wait and watch”—allow the new series to go live, observe several months of data to confirm a durable downward shift in the inflation trajectory, and only then consider policy action. Acting on assumptions rather than evidence could leave the RBI vulnerable if actual inflation proves stickier than the revised index suggests.

Q2: Why is “liquidity provision” considered more important than another rate cut for effective monetary policy transmission right now?
A2: Effective transmission requires that reductions in the policy repo rate translate into lower borrowing costs across the economy. Recently, transmission has been hampered by a liquidity deficit in the banking system, which keeps short-term market rates above the repo rate, and a large government borrowing program, which pushes long-term bond yields up. In this environment, another small repo rate cut would have a limited impact on market yields. In contrast, the RBI can use tools like Open Market Operations (bond purchases) to inject durable liquidity directly. By alleviating the liquidity deficit, the RBI can force short-term rates down to the repo rate and help contain the rise in long-term yields, thereby ensuring the existing accommodative stance actually reaches borrowers. Liquidity management is thus a more direct and potent tool for influencing real-world credit conditions at this juncture.

Q3: How do weak Foreign Direct Investment (FDI) flows influence the RBI’s rate decision?
A3: The dramatic fall in net FDI inflows (to $1 billion in FY25) weakens a key pillar of support for the Indian rupee, as FDI represents durable, long-term capital. In a global environment of high U.S. interest rates, a decision by the RBI to cut rates would widen the interest rate differential between India and the U.S., making India less attractive for foreign capital. This could further discourage foreign investment and potentially trigger portfolio outflows, exerting depreciation pressure on the rupee. A weaker rupee increases the cost of imports (like oil), fueling imported inflation. Therefore, maintaining the policy rate helps stabilize the currency by not adding an additional incentive for capital to seek higher yields elsewhere, thereby protecting the external account and insulating the economy from imported inflation.

Q4: If GDP growth is expected to remain strong (~6.6-7.2%), why is there any discussion of a rate cut at all? Doesn’t strong growth argue against easing?
A4: This is the core of the RBI’s dilemma. While strong growth typically reduces the need for monetary stimulus, the discussion of a cut stems from two factors: 1) the projected disinflation from the CPI revision, which could create theoretical space for easing if inflation falls durably toward 4%, and 2) the desire to provide some support to ensure the growth momentum is sustained as it moderates from 7.5% to ~6.6%. However, the analysis argues convincingly that with growth remaining above potential, the economy no longer needs cyclical demand support. The binding constraints are now structural (e.g., ease of doing business). A rate cut in this context would be ineffective at boosting sustainable investment and could risk stoking inflationary pressures or asset bubbles without solving the real bottlenecks.

Q5: What does the analysis mean by “keeping some powder dry,” and why is it a crucial consideration?
A5: “Keeping powder dry” is a metaphor for preserving policy ammunition—in this case, the option to cut the repo rate from its current level of 5.25%. The global economic environment is highly uncertain, with risks from geopolitics, trade fragmentation, commodity price spikes, and financial volatility. If the RBI were to enact a “final” cut now, it would reduce its repo rate to 5.00%, leaving less room to maneuver if a severe external or domestic shock hits later in FY27. By holding steady now, the RBI preserves a valuable 25-50 bps of potential rate cuts as an emergency buffer. This optionality is crucial for a central bank; it allows for a robust counter-cyclical response if the economy faces an unexpected downturn, thereby enhancing macroeconomic stability. Using the “powder” prematurely for a marginal gain would be a strategic misstep.