MC EXPLAINER Will easing inflation pave the way for more rate cuts?

After the Consumer Price Index (CPI) inflation fell further in June, the Q1FY26 CPI inflation reached 2.7 percent, 20 bps lower than the RBI’s estimate of 2.9 percent.

Economists tracking July headline inflation estimate that inflation may further be pushed down to a sub-2 percent number (1.8-1.9 percent), with prices of cereals, pulses, and fruits easing further. This will allow the RBI to revise downwards its forecast on inflation for the upcoming quarters in the August policy.

Aditi Nayar, Chief Economist at ICRA said Q2FY26 (she expects) inflation print to materially undershoot the MPC’s current forecast of 3.4 percent amid the benign outlook for July 2025 (1.9 percent), which is likely to prompt the MPC to cut its FY26 CPI inflation projections further from the current 3.7 percent.

“We think CPI inflation in July could be further lower. Average CPI inflation in Q1 FY25-26 has undershot the MPC's forecast by 20bp and may well continue to surprise on the lower side in Q2,” Barclays said in a report.

Will inflation outlook prompt a rate cut?

Perhaps so, as a few economists are of the view that the easing inflation and outlook may give comfort to the central bank to cut rates. But a pause in any action on the rate is quite likely in the August policy and cannot be ruled out, as a pause will allow the RBI to assess incoming data on the impact of monsoons on inflation, and the impact of past rate cuts on the growth trajectory.

The MPC is expected to meet between August 4 and 6 for another round of rate setting deliberations and by then the country would have witnessed at least a partial spell of monsoon. This would leave RBI with incremental data to take a view on factors affecting interest rate and the subsequent MPC in October this year may be more well informed to take a calculated move on the benchmark rate.

“There will also be more clarity of the impact of US bilateral trade tariffs on India’s merchandise exports. India is expected to reach a trade agreement with the US by August. Further there will be some clarity on Fed policy outlook, as impact of tariffs become more visible on US growth and inflation,” an IDFC First Bank report said.

How many rate cuts can be expected in 2025?

The expectation is that there will be at least two more rate cuts by the end of calendar year 2025, which might take the terminal lending rate to 5 percent, thereby providing the much needed impetus for growth in FY27.

“The space for fiscal policy to further support growth (post the income tax cut) is limited with downside risk to tax collection and nominal GDP growth. Hence monetary policy will have to continue to do the heavy lifting to support growth,” the IDFC First Bank report added.

Barclays, in its report, said the rate cutting window will close shortly as they expect CPI inflation to rise to above 4.5 percent in Q4FY26. “It may thus become rather challenging for the RBI MPC to deliver a cut post October-December 2025.”

Will rate cut translate to growth?

In order to revive economic momentum, the central bank uses repo rate cuts as a part of broader monetary easing. By making borrowing cheap and increasing spending power, RBI hopes to push GDP growth upwards. GDP growth has been lagging in the last few quarters.

Usually, when credit is cheaper and liquidity improves, it becomes conducive for business to invest more and also allows consumers to spend more, which leads to an increase in demand and sets off a virtuous cycle of growth. On June 25, Moneycontrol had reported that growth led by a congenial interest rate situation may be a tad bit delayed.

Will Indian currency get impacted in near term?

Money market experts are of the opinion that domestic currency may get slightly impacted due to further easing of rates as the spread between Indian and US interest rates may narrow, thereby making a favourable case for foreign investors to pull back money from India.

Usually, when the spread or gap between yields in bonds issued by two countries narrows, it is common for foreign investors to pull back funds from emerging economies and park it in less risky destinations,  invariably their home countries. Economics also favours this movement as lower returns in the home country or a less risky nation is preferred over lower returns from a moderate- to high-risk nation, especially when adjusted for cost of doing business outside of the home country.

In June this year, foreign portfolio investors (FPIs) pulled out over $1.06 billion from Indian debt, after a sharp outflow of $3.03 billion in April.

Policy rate differential of India and US

Currently, the policy rate differential between India’s central bank and the US Federal Reserve is 100-125 bps. The US Federal Reserve's Federal Open Market Committee (FOMC) has kept interest rates unchanged at 4.25 percent to 4.5 percent following the June 17-18 meeting. After the 50 bps rate cut in June, repo rate has been trending at 5.50 percent.

It's likely that the possibility of an imminent rate cut in the US is bleak, given the country's inflation footprint at 2.7 percent is higher compared to earlier levels of 2.4 percent. On the other hand, there is expectation that the Indian central bank may cut rates in August policy and should this be the case, the interest rate parity or differential may further shrink.