Over recent months, there has been a notable shift in the focus of monetary policy towards growth as inflation pressures have eased. Since December 2024, the Reserve Bank of India (RBI) has concentrated on infusing durable liquidity to facilitate transmission and credit off-take. The total durable liquidity infusion, estimated at INR 6.2 trillion, has been implemented through three main instruments: the Cash Reserve Ratio (CRR) cut, Open Market Operations (OMO) purchases, and USD/INR buy-sell swaps. Following this, the RBI reduced the policy rate by 25 basis points in February, with expectations of further cuts in upcoming policies. The significant decrease in inflation pressures has created room to further reduce interest rates.
Growth conditions are not particularly weak; however, there is a loss of momentum due to the downward pressures exerted by monetary policy, fiscal policy, and credit impulses. Last year, monetary policy tightened due to substantial foreign exchange sales by the RBI to limit the depreciation pressure on the INR. This resulted in the interbank liquidity deficit increasing to INR 2 trillion in January 2025 from surplus conditions until November 2024. Simultaneously, fiscal policy also became inadvertently contractionary, with a sharp slowdown in capital expenditure by both the central and state governments. Additionally, the combination of tight liquidity conditions and macroprudential norms led to a slowdown in credit impulses.
Currently, monetary policy is pivoting towards a growth focus, with inflation pressures receding. The significant liquidity infusion and the rate cut in February raise questions about whether the monetary policy stance is truly neutral or if it has become accommodative. To answer this, an examination of real policy rates and their impact on liquidity is necessary. Real policy rates stand at 2.5%, based on the Q4 FY25 inflation estimate of 3.8%. This is considered restrictive compared to the RBI’s estimate of the neutral real rate, which is between 1.4% and 1.9%. Based on a Q4 FY26 inflation estimate of 4.0%, real rates remain in a restrictive zone at 2.3%. Consequently, the RBI will need to cut policy rates by at least 50 basis points further to bring real policy rates into the neutral zone. A 25 basis point cut is expected in both April and June to ensure monetary policy remains neutral. A neutral policy stance implies no positive or negative impact on growth from monetary policy.
Examining liquidity, the impact of the significant durable liquidity infusion is evident. As of March 2025, system liquidity deficit remains elevated at INR 1.5 trillion. With the incorporation of increased government expenditure and further liquidity infusion planned for March, the system liquidity deficit could end in a mild surplus or deficit. This situation raises the question of whether the policy is accommodative or simply aligns liquidity settings to a neutral position from restrictive levels. The RBI will need to infuse INR 2 trillion of durable liquidity in FY26 to ensure system liquidity is slightly positive. Reviewing the growth of the RBI balance sheet provides insight into the ongoing quantitative easing. As of March 7, 2025, the RBI balance sheet growth tracked at 7%, rising from 5.4% in November 2024. However, this remains below nominal GDP growth, indicating a reduction in the balance sheet size as a percentage of GDP. By March-end 2025, the RBI balance sheet as a percentage of GDP could decrease to 23%, slightly below last year’s level of 23.6% in FY24. Thus, despite substantial liquidity infusion, from a liquidity standpoint, monetary policy is transitioning from contractionary to a neutral setting, with the majority of liquidity infusion already completed under the neutral stance.
An additional factor concerns the signaling utility of policy stance. During Dr. Patra’s tenure, the stance was decoupled from liquidity conditions and linked to the future policy rate path, emphasizing signaling. A neutral stance suggests equal probabilities for a rate hike or cut, whereas an accommodative stance indicates that rate hikes are unlikely, and a deeper rate cut cycle is possible. The last change from a neutral to an accommodative stance occurred in June 2019, maintained until February 2022, during which policy rates were reduced by 200 basis points. Given the expectation of an additional 50 basis point cut in the remainder of 2025, a change in stance is unnecessary, as it constitutes a shallow rate cut cycle. Another consideration is the uncertainty regarding Fed policy due to tariffs and varying fiscal policies. The latest Fed dot plot suggests that, despite a slowdown in U.S. growth, most members forecast only a 50 basis point cut in 2025. A neutral policy stance is appropriate for a shallow rate cut cycle amid heightened global uncertainty.
A neutral stance is well-suited for navigating a highly volatile global environment. Central banks worldwide are making decisions on a meeting-by-meeting basis, maintaining policy flexibility to respond to evolving domestic and external factors. The article is authored by Gaura Sengupta, Chief Economist at IDFC FIRST Bank.