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ECONOMICS

Decision

The RBI monetary policy committee (MPC) surprised markets by a double-barrelled move on Friday. The repo rate was lowered by 50bp to 5.5%, in contrast to expectations of a 25bp reduction. Decision received a 5:1 vote, with one member leaning towards a smaller 25bp cut. With this, the benchmark rate has been cumulatively lowered by 100bp in 2025. The accompanying policy stance that was previously dialled to ‘accommodative’ was returned to ‘neutral’. Alongside, the cash reserve ratio was reduced by 100bp to 3%, injecting an estimated INR 2.5trn to the domestic banking system. The staggered CRR cut will be undertaken in four tranches. Markets will be keen to understand if the ‘new normal’ for the CRR is 3%, which usually used to be the level for crisis periods. While growth forecast has been maintained, the FY26 inflation forecast was lowered to 3.7% from 4.2% previously.

The policy statement added, the MPC is “carefully assessing the incoming data and the evolving outlook to chart out the future course of monetary policy in order to strike the right growth-inflation balance” and “monetary policy is left with very limited space to support growth”. We expect a pause here on.

Outlook

The RBI monetary policy committee (MPC) banked on soft inflation to frontload policy easing measures, while growth is expected to ease below 7% this year. Easing food costs and benign core-core inflation (core ex precious metals) are likely to keep 2Q25 inflation close to ~3%, tracking our full-year forecast at 3.8% (downside risks), below the central bank’s target. Add to this, the benign core prints also point to economic slack, limiting the risk of second derivative impact on price pressures.

In recent months, an accommodative liquidity view had also pushed overnight rates to below the repo rate, acting as a de facto cut. The central bank had also started to cut its FX forward positions, countering its impact through a string of open market operation purchases. This saw the total net short dollar position in the forwards book fall from $52.4bn in April vs $78bn in February. As we had noted earlier, more than two-thirds of these maturities were in the 3M to 1Y bucket, necessitating staggered counteraction, and were unlikely to be rolled over. Besides the other salutary motives, liquidity infusion via the CRR cut would also aid this process, while shielding the currency.  

While growth momentum is weakening at the margin, this step to frontload easing measures is likely a pre-emptive move to arrest further slowdown in economic activity. Data out last week had shown real GDP growth post a strong 7.4% yoy in 1Q25 (4QFY25) vs our forecast at 7% and consensus at 6.8%. This marked an increase from an upwardly revised 6.4% quarter before and took FY25 average to 6.5%, in line with our projection. As we noted in Growth and monsoon watch, the headline real GDP received a one-off boost from net indirect taxes which widened the wedge between the GDP and GVA gauges. The supply measure GVA which rose 6.8% in 3QFY from 3QFY’s 6.5% provided a better handle on the underlying growth impulse. A catch-up in public investments (fixed asset investments rose 9.4% yoy vs 5.2% in 3QFY), firmer farm output, tailwind to rural demand, and contribution from net exports (on lower imports) were key support areas, whilst urban demand softened besides lacklustre private capex.

In the year ahead, consumption is likely to receive a hand from easing inflation and flush liquidity conditions, a timely monsoon and income tax cuts. Other engines of growth are likely to moderate, in midst of a weak credit impulse, modest budgeted increase in centre’s fiscal spending and global uncertainties impacting exports and the private sector capex cycle (India: Trade thaw, agreements and tailwinds).  Our forecast at 6.1% yoy growth in FY26 is more conservative that the central bank’s 6.5% estimate.

With our forecast of terminal rate being met, further rate reductions are likely if the growth momentum weakens anew.

Markets view

INR Rates: The reach for yield will kick in

The aggressive frontloading of rate cuts and RRR cuts mean that liquidity will be flush and base level of short-end rates much lower. Short-to-belly tenor IGBs rallied sharply, with yields down by some 4-10bps. Interestingly, after a brief rally, 10Y yields are now inching higher for the day. The ultras are performing even weaker. This could imply investors swapping duration for where they see greatest RBI support and / or a greater reflection of overheating / fiscal worries further out. There are a few considerations at this point. First, the RBI may be largely done with easing. Even if they do ease, it might require weaker data. A further grind lower in short end yields may be possible under benign global conditions, however, the largest part of the adjustment may be largely done. Second, we think that there may be interest to extend duration out to 10Y segment when markets settle. The 2Y/10Y segment has widened out to 63bps, levels not seen since 2022. The yield pickup would likely prove enticing to investors in an environment where the USD is weak.

USD/INR: A range with a downside bias

The RBI’s ability to lower three rate cuts in the first half of this year underscored the underlying global USD weakness landscape. In fact, USD/INR peaked near 88 around the first rate cut on February 7 and resumed falling from 86.7 at the second easing on April 9, to a low of 84 at the start of May, before moving in a 85-86 range over the past month.

Today’s larger-than-expected 50 bps rate cut and 100 bps cut in the cash reserve ratio should support INR. We noted that following the INR’s decline to a lifetime low of 88 (intra-day) on February 10, the RBI’s significant USD10bn 3Y USD/INR swap auction on February 28 provided the rupee liquidity injection to address the cash deficit in the banking system constraining credit availability and economic activity. By reestablishing the effective transmission of monetary policy, the RBI also restored market confidence by putting a floor to the SENSEX. The second rate cut on April 9 provided another stronger boost, and this third cut is likely to do the same.

However, we see scope for USD/INR to consolidate in an 84-86 range with a downside bias, aligning with its historical tendency to regain equilibrium after sharp currency movements. Following the correction of the INR’s overvaluation on a REER basis, the RBI started intervening on both sides of the forex market to discourage one-way currency bets, favouring currency stability to safeguard export competitiveness amid Trump’s tariff threat to global trade. We will consider lowering USD/INR’s forecast if the US Federal Reserve pivots towards a rate cut later this year and sets the stage for more USD weakness.


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