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Banking Sector Reforms

India’s central bank holds interest rates steady: What drove the policy decision

Explained | Economics | Mains Paper 3: Indian Economy

Why in the News?

The Reserve Bank of India has chosen to hold the repo rate steady after cutting it by 25 bps in December to 5.25%, completing a cumulative reduction of 125 bps in 2025. The pause follows the Union Budget and signals that the central bank sees no immediate urgency for further easing. This is significant because inflation remains within the tolerance band, growth projections have been revised upward to 7.4% for FY26, and global geopolitical tensions continue to intensify. The decision marks a cautious “wait-and-watch” approach rather than aggressive monetary easing, which reflects confidence in domestic resilience and acknowledges rising external headwinds.

Why Did the Monetary Policy Committee Pause the Rate Cuts?

  1. Cumulative Easing Completed: Repo rate reduced by 25 bps in December to 5.25%, bringing total reduction in 2025 to 125 bps.
  2. Favourable Inflation Outlook: CPI inflation projected at 4% in Q1 and 4.2% in Q2 of next fiscal year; remains below the tolerance band.
  3. Underlying Inflation Low: Core inflation trends remain moderate despite price pressures in precious metals (60-70 bps contribution).
  4. Strong Domestic Momentum: Robust consumption projected to expand by about 7% in FY26.
  5. Budgetary Support: Income tax cuts and GST rationalisation announced in FY26 Budget expected to support demand.
  6. Statistical Support: Low GDP deflator effect strengthens first-half growth figures.

How Do Trade Deals Influence Monetary Stability?

  1. Strategic Trade Agreements: India signed or concluded negotiations with US, EU, Oman, and New Zealand.
  2. External Shock Cushioning: Trade pacts expected to soften global uncertainties.
  3. Export and Investment Boost: US trade deal seen as supportive of India’s exports and investment flows.
  4. Geopolitical Vigilance: External headwinds have intensified since last policy review; requires close monitoring.

What Is the Updated Growth and Inflation Outlook?

  1. Revised GDP Forecast: FY26 growth raised to 7.4% from earlier 7.3%.
  2. Government Estimate Alignment: First advance estimate places FY26 real GDP slightly above 7.4%.
  3. Improved Economic Momentum: Growth described as strong and stable.
  4. Marginal Inflation Revision: Slight upward revision due to precious metal prices.
  5. Target Anchoring: Inflation continues to align with the medium-term 4% target.

What Is the Impact on Lending and Deposit Rates?

  1. Repo-Linked Loans Stable: No immediate change in EMIs for repo-linked borrowers.
  2. Marginal Cost of Funds based Lending Rate (MCLR) Flexibility: Banks may revise MCLR-based lending rates depending on liquidity and funding conditions.
  3. Deposit Rates Steady: Rates expected to remain stable unless liquidity pressures intensify.
  4. Funding Cost Sensitivity: Deposit pricing may adjust if sustained funding stress emerges.

What Does the RBI’s Approach Indicate?

  1. Cautious Pause: No urgency to alter rates amid stable growth and controlled inflation.
  2. Wait-and-Watch Stance: Close monitoring of geopolitical developments.
  3. Fiscal-Monetary Coordination: Budget measures complement monetary stance.
  4. Macro Stability Signal: Reinforces stability in credit markets and repayment obligations.

Conclusion

The RBI’s decision reflects calibrated policy management amid stable domestic fundamentals and rising external uncertainties. Growth remains firm at 7.4%, inflation anchored near 4%, and trade agreements offer external cushioning. The pause signals confidence in macroeconomic stability while retaining policy flexibility.

Value Addition

Impact of a Steady Repo Rate

Impact on Borrowers

  1. EMI Stability: Keeps repo-linked loan EMIs unchanged; ensures repayment certainty.
  2. Credit Continuity: Maintains lending momentum without tightening financial conditions.
  3. Investment Predictability: Supports business planning by reducing policy volatility.
  4. MCLR Flexibility: Allows banks to adjust marginal cost-based lending rates depending on liquidity and funding costs.

Impact on Depositors

  1. Deposit Rate Stability: Prevents immediate reduction in fixed deposit returns.
  2. Liquidity Sensitivity: Deposit pricing adjusts only if sustained funding pressures arise.
  3. Savings Behaviour: Maintains incentive structure between savings and consumption.

Impact on Banking System

  1. Net Interest Margin Stability: Preserves spread between lending and deposit rates.
  2. Balance Sheet Planning: Supports funding cost predictability.
  3. Liquidity Management: Enables calibrated response to evolving liquidity conditions.

Impact on Inflation

  1. Anchored Expectations: Signals confidence that inflation remains near 4% target.
  2. Demand Containment: Avoids excessive demand stimulation.
  3. Transmission Pause: Allows earlier 125 bps cumulative easing to transmit fully into the economy.

Impact on Growth

  1. Growth Support: Maintains accommodative stance without overheating.
  2. Consumption Boost Alignment: Complements Budget measures such as income tax cuts and GST rationalisation.
  3. External Stability: Provides cushion amid intensified geopolitical headwinds.

What Happens If Repo Rate Increases? (Tightening Cycle)

Inflation Control

  1. Demand Compression: Reduces aggregate demand through higher borrowing costs.
  2. Expectations Management: Signals anti-inflation commitment.
  3. Currency Support: Strengthens domestic currency by attracting capital inflows.

Credit Impact

  1. Higher EMIs: Raises repayment burden for floating-rate borrowers.
  2. Investment Slowdown: Discourages capital expenditure.
  3. Housing and Auto Demand Impact: Sensitive sectors experience contraction.

Banking Effects

  1. Higher Deposit Rates: Banks raise deposit rates to attract funds.
  2. Credit Growth Moderation: Loan disbursement slows.

Macroeconomic Trade-off

  1. Lower Growth: Tight monetary stance reduces GDP momentum.
  2. Improved Current Account Stability: Reduced imports due to lower domestic demand.

What Happens If Repo Rate Decreases? (Easing Cycle)

Growth Acceleration

  1. Lower Borrowing Cost: Stimulates investment and consumption.
  2. Credit Expansion: Encourages loan uptake across sectors.
  3. Multiplier Effect: Boosts demand-driven sectors such as housing and MSMEs.

Inflation Risk

  1. Demand-Pull Inflation: Excess liquidity may raise price levels.
  2. Asset Price Inflation: Risk of stock and real estate overheating.

External Sector

  1. Currency Depreciation Risk: Lower rates may reduce foreign capital inflows.
  2. Export Competitiveness: Depreciation may support exports.

Financial Stability

  1. Liquidity Expansion: Increases systemic liquidity.
  2. Potential Asset Bubbles: Excess credit may distort asset markets.

PYQ Relevance

[UPSC 2019] Do you agree that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons.

Linkage: The question evaluates whether steady GDP growth and low inflation indicate macroeconomic stability, focusing on the growth-price balance central to monetary policy. The RBI’s steady repo rate, after cumulative cuts, reflects confidence that 7.4% growth and ~4% inflation remain balanced, signalling macro stability.

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