Monetary Policy: Mission accomplished, now over to you

Sanjay Malhotra, Governor, Reserve Bank of India

By Soumyajit Niyogi 

The Monetary Policy Committee (MPC) has taken a bold and decisive step by frontloading all anticipated measures in a single sweep. The policy rate has been cut by 50 basis points— from 6% to 5.5%—, accompanied by a staggered 100 basis point reduction in the Cash Reserve Ratio (CRR) and followed by a shift in the policy stance from ‘accommodative’ to ‘neutral.’ In a candid acknowledgment, the MPC stated that ‘under the current circumstances, monetary policy is left with limited space to support growth.’

This signals a strategic pivot: the baton has now been passed. With the monetary authority having delivered its part—within a span of less than five months—, the onus now shifts to the banking system and domestic economic drivers to reignite the animal spirits and propel aggregate demand .

Though the measures appear bold and decisive, they raise two pivotal questions. First, should the banking sector begin to treat the proposed 3% CRR as the new normal or a potential floor—departing from the conventional 4% benchmark? This would imply a structural shift, aligning CRR with long-term equilibrium in harmony with LCR requirements. Alternatively, is this merely a short-term adjustment aimed at stimulating demand, suggesting that CRR could revert to 4% or thereabouts in alignment with future policy recalibrations? The answer will shape expectations around the central bank’s evolving stance.

The second question is why there is shift in the stance from accommodative to neutral within a span of two months? The monetary policy stance reflects the central bank’s intent and its long-term outlook on macroeconomic fundamentals. In contrast, the strategy — particularly with regards to liquidity management — is inherently short- term and tactical, aimed at complementing the broader policy stance. The tool being used to pursue liquidity strategy can still vary based on evolving conditions. For instance, sustained and sizeable foreign portfolio investment inflows may necessitate sterilization, often through tools such as open market operation (OMO) sales. And OMO sale in general is perceived as a tightening measures. Similarly, liquidity could be tightened to ensure short-term rates serve as a guardrail against excessive volatility in the rupee.

System liquidity is currently hovering around INR 2 trillion, having peaked at ₹INR3.03 trillion lakh crore —even before factoring in the RBI’s dividend transfer and the ensuing government expenditure. Additionally, the anticipated 1% reduction in the Cash Reserve Ratio (CRR) during Q2 and Q3 of FY26 is expected to inject another INR 2.5 lakh crore of loanable funds into the banking system.

Should foreign portfolio investment flows revive meaningfully, the resulting liquidity surge could overwhelm the system, distorting short-term interest rates—a key risk to both financial stability and currency management.

In such a scenario, the RBI may be compelled to sterilize the excess liquidity through OMO sales. To avoid any signal extraction issues—where markets misinterpret tactical liquidity actions as shifts in policy stance,— a clearly articulated neutral stance would be essential.

What should we now expect from the financial system? The answer is far from straightforward. The credit momentum is mostly driven by the retail segment, while wholesale demand remains subdued. This presents a conundrum for policymakers and lenders alike. The classical transmission of monetary policy — stimulating aggregate demand through lower interest rates — will now be tested more closely. In particular, the interest rate elasticity of credit demand becomes a focal point, especially in a financial landscape increasingly shaped by the growing footprint of (NBFCs). Yet, a key friction remains: the transmission mechanism within the NBFC sector is still uneven, largely due to the absence of standardized benchmark-linked pricing and heterogeneous lenders and borrowers. For monetary policy to be truly effective, this gap must be addressed and ironed out.

(By Soumyajit Niyogi- Director at India Ratings & Research – A Fitch Group Company.)

(The views expressed here are my own and do not necessarily reflect those of the organization.)