As fiscal consolidation continues in FY26, monetary support will be key to sustaining growth

Sneha Pandey

Sneha Pandey, Fund Manager – Fixed Income at Quantum Mutual Fund

As the Reserve Bank of India (RBI) gears up for its June 6 Monetary Policy Committee (MPC) meeting, all eyes are on how it will balance cooling inflation and moderating growth.

The annual rate of inflation is down to 3.2 percent—well below the RBI’s 4 percent  target—and food prices even seeing deflation (thanks to falling vegetable and pulse costs). The early onset of the monsoon this year also brings further optimism for crops like paddy and soybean.

Q4FY25 GDP growth surprised at 7.4 percent (beating even the market’s most optimistic estimates), driven broadly by lower subsidies and a capex surge. GVA or gross value added also outperformed at 6.8 percent, led by agriculture and construction. One-off boosts—like back-loaded government capex and lower real imports—supported Q4 growth, but the underlying momentum remains modest. Private consumption slowed to 6 percent, dragged by urban demand, though rural demand stayed strong on good harvests and an expected above-normal monsoon.

The construction and real estate segments are likely to stay resilient. Lower energy costs and better margins should help in FY26, though weak external demand may weigh on exports. We now forecast FY26 GDP at 6.5 percent.

As fiscal consolidation continues in FY26, monetary support will be key to sustaining growth, with scope for further easing if external headwinds intensify. Against this backdrop, after lowering its policy rate by 50 basis points (bps) so far, the RBI is likely to ease rates further, potentially lowering the repo rate to 5.5 percent by end-2025, with a 25 bps cut in June 2025 and another in August 2025, alongside ongoing liquidity support.

Our internal models indicate both banking and durable liquidity are currently comfortable aided by G-sec maturities, front-loaded OMOs or open market operations, and signs of government spending. The RBI dividend sharply lifted durable liquidity to 2.6 percent of NDTL or net demand and time liabilities, though rising cash demand—more about holding than withdrawals—suggests strong rural transactions post-harvest.

In tight liquidity, the effective rate nears the Marginal Standing Facility (MSF); in surplus, it trends towards the Standing Deposit Facility (SDF). So, while headline rate cuts total 50 bps, the effective rate has dropped 100 bps—from the MSF (6.75 percent in January) to the SDF (5.75 percent now).

Following the RBI’s Rs 2.69 lakh crore dividend, we expect OMOs to slow, with no more than Rs 1 lakh crore in OMOs until September 2025, barring significant forex outflows. That said, some additional OMOs may be required if maturing short dollar positions drain liquidity, necessitating reserve money creation.

Historically, the RBI has rarely sustained core liquidity above 1 percent of NDTL, except in extraordinary periods. We believe this signals a shift in the RBI’s liquidity approach, likely steepening the yield curve, boosting demand for short-term bonds, and driving a near-term bond market rally.