With meaningful RBI action, interest rates likely to remain softer; bond yield curve may flatten over medium term

Reserve Bank of India

By Deepak Agrawal, CIO-Debt at Kotak Mahindra AMC

The Reserve Bank of India’s (RBI) monetary policy had taken the market by surprise with 3 actions: Repo rate cut of 50 bps, cash reserve ratio (CRR) cut by 100 bps in 4 tranches starting from September 2025, change in stance to “neutral”. This is the same as RCB surprising the cricket fans after winning the IPL after 18 years.

The Monetary Policy Committee (MPC) voted 5:1 to cut the repo rate by 50 bps to 5.50 percent, with one external member, Saugata Bhattacharya, voting for a 25-bp rate cut. MPC has changed the stance back to “neutral” from “accommodative” (changed from neutral in the April 2025 policy only). The reduction in the repo rate will take effect immediately. As a result, under the liquidity adjustment facility (LAF), the standing deposit facility (SDF) rate was reduced to 5.25 percent, and the marginal standing facility (MSF) and bank rate were reduced to 5.75 percent.

The real GDP growth projected by the RBI for FY2025- 26 has remained unchanged at 6.50 percent since the April 2025 policy. The private consumption, which accounts for more than 50 percent of the GDP growth, has been improving with FY2024- 25 growth at 7.2 percent from 5.60 percent in the preceding year. The agricultural sector remains well built, with supply remaining pleasant for major food crops. Moreover, as per the high-frequency indicator, investment activity is improving in the economy. The downside to growth remains the geopolitical conflicts, with uncertainty regarding the US tariffs. The RBI’s quarterly forecast for FY2025- 26 GDP growth rate is as follows – Q1: 6.50 percent; Q2: 6.70 percent; Q3: 6.60 percent; and Q4: 6.30 percent, with risks evenly balanced.

The headline inflation projected by the RBI for FY2025- 26 has been reduced to 3.70 percent from 4.00 percent in its April 2025 policy. The food inflation has witnessed the sixth consecutive decline since October 2024. The headline inflation has been below the RBI’s medium-term target of 4 percent with a range of +/- 2 percent. The core inflation has remained around ~4.20 percent in April 2025 and is anticipated to stay stable going forward with the softening of international commodity prices. The FY2025- 26 quarterly inflation projections by RBI are as follows – Q1: 2.90 percent; Q2: 3.40 percent; Q3: 3.90 percent,t and Q4: 4.40 percent with risks remaining evenly balanced.

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Deepak Agrawal

Chief Investment Officer (Debt Fund)|Kotak Mahindra Asset Management Company

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On the liquidity front, the RBI has infused Rs 9.5 lakh crore (OMO of Rs 5.2 lakh crore, term VRR of Rs 2.1 lakh crore, and forex swap of Rs 2.2 lakh crore) of durable liquidity. Given the surplus liquidity, the weighted average call rate (WACR) has been trading lower by 16 bps beneath the repo rate from April 2025 to 4th June 2025, against 6 bps over the repo rate from February 2025 to March 2025.

Moreover, the RBI has done 100-bps unexpected cut in cash reserve ratio (CRR) to 3 percent of NDTL which will be conducted in a phased manner of 25 bps in four equal parts with effect from the fortnights starting at September 6, followed by October 4, November 1, and November 29, 2025 respectively.

Consequently, this action will add primary liquidity of ~Rs 2.5 lakh crore by the end of the CY2025, and this will keep the liquidity in ample surplus even after considering CIC (currency in circulation) increase, maturity of $5 billion forex swap, etc, till the end of CY2025. This will ensure the faster transmission of monetary policy rate cuts in the Indian economy. The RBI governor further stated that the RBI remains committed to providing sufficient liquidity to the banking system and will take proactive measures as warranted.

Recently, the European Central Bank (ECB) reduced the benchmark interest rate for the 8th consecutive time. In the Global market, different Central Banks are behaving differently based on the different macro conditions. The US Federal Reserve has kept the rate unchanged so far in 2025, with fed fund futures predicting a 50-bps rate cut in the remainder of 2025. The headwinds remained from the global market with continued uncertainty on US tariffs, and tense geopolitical conditions in parts of the world.

Given the backdrop, we observe that the RBI has front-loaded the interest rate cut with a reduction in CRR (in 4 tranches from September 2025). Owing to the change in policy stance to “neutral”, which was not in line with the market expectations and the same resulted in a steepening of the yield curve (10/30 Year Indian government bond moved up by ~2/5 bps).

However, we believe that the action taken is meaningful, rates are likely to remain softer, and the yield curve may flatten (10/30 year) over the medium term. While the Indian macro environment is benign, with the projected inflation of 3.7 percent for FY26 and real rate of 1.50 percent, the terminal repo rate can still go to 5.25 percent. As explained, future rate cuts will depend on the pitch conditions (incoming macro data) with the game strategy of a test cricket match rather than a T20 match, which is short-term focused.

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