Growth conditions are not that weak, but there is a loss of momentum due to downward pressure exerted by monetary policy, fiscal policy, and credit impulse. Monetary policy became tight last year due to substantial FX sales undertaken by the RBI to limit depreciation pressure on INR. This resulted in interbank liquidity deficit surging to INR2tn in January 2025 from surplus conditions till November 2024. At the same time, fiscal policy also turned inadvertently contractionary with sharp slowdown in capital expenditure by the government both Centre and the state government. Meanwhile, the combination of tight liquidity conditions and macro prudential norms resulted in credit impulse slowdown.
Monetary policy is now changing gears and is focusing more on growth, with inflation pressures behind us. The large liquidity inflation and one rate cut in February raises the question is monetary policy stance really neutral or has it become accommodative? To answer this, we look at real policy rates and impact on liquidity. Real policy rates are currently 2.5%, based on Q4FY25 inflation estimate of 3.8%. This is considered clearly restrictive as per RBI’s estimate of the neutral real rate, which is between 1.4% to 1.9%. Based on our Q4FY26 inflation estimate of 4.0%, real rates remain in a restrictive zone at 2.3%. Hence, RBI will need to cut policy rates by at least 50bps further to get real policy rates in the neutral zone. Hence, we expect a 25bps cut in April and a 25bps cut in June, just to ensure monetary policy remains neutral. The neutral policy stance implies that monetary policy doesn’t have positive or negative impact on growth.
Now let’s look at liquidity, what has been the impact of the substantial durable liquidity infusion. System liquidity deficit remains elevated at INR1.5tn in March 2025. Incorporating pick-up in government expenditure and the liquidity infusion to be conducted in the remainder of March 2025, system liquidity deficit could end in a mild surplus or mild deficit. So is this accommodative policy or is it just getting liquidity settings to neutral from restrictive. Note, RBI will need to infuse INR2tn of durable liquidity in FY26 to ensure that system liquidity is a mild positive. We look at the growth of RBI balance sheet to get a sense of quantitative easing taking place. As of March 7th 2025, RBI balance sheet growth is tracking at 7% which has risen from 5.4% as of November 2024. This is still below nominal GDP growth and hence as % of GDP, RBI balance sheet size is reducing. We estimate by March-end 2025, RBI balance sheet as a % of GDP could be 23% which is slightly below last year levels (23.6% in FY24). Hence despite the incredible quantum of liquidity infusion, from a liquidity standpoint, monetary policy is moving from contractionary to neutral setting. The lion share of the liquidity infusion has already taken place under the neutral stance.
There is another factor which we haven’t discussed, which is the signaling utility of policy stance. During Dr Patra’s tenor, the stance was de-linked from liquidity conditions and linked to future policy rate path, i.e, signaling. A neutral stance implies that the probability of a rate hike and a cut is equal. An accommodative stance implies that rate hikes are off the table and a deeper rate cut cycle is on the cards. The last time the stance was changed from neutral to accommodative was in June 2019 and the stance was retained till Feb 2022. Over this period the policy rate was reduced by 200bps. Given our expectation of an additional 50bps cut in the remainder of 2025, a change in stance isn’t required as it’s a shallow rate cut cycle. Another factor is the uncertainty on Fed policy given the uncertainty due to tariffs and changing fiscal policy. The latest Fed dot plot indicates that despite a growth slowdown in the US, the majority of members only see a 50bps cut in 2025. A neutral policy stance makes sense in the case of a shallow rate cut cycle and heightened global uncertainty.
A neutral stance is perfect for monetary policy navigating highly volatile global environment. Central banks globally are taking decisions meeting-by-meeting, retaining policy flexibility to respond to changing domestic and external impulses. (The author of the article is Gaura Sengupta, Chief Economist, IDFC FIRST Bank)
