Bibtex
Endnote
RIS
The MPC’s decision to cut the policy rate by 25 basis points to 5.25 per cent, on the conclusion of its last bi-monthly meeting of 2025 on December 5 was contrary to the ‘consensus’ opinion of a few senior bankers and also the majority opinion of a panel of economists polled earlier in this regard. However, this latest cut in the rate was not wholly unexpected, given the sharp drop in CPI inflation to an all-time low of 0.25 per cent in October, 2025.
The real rates of interest are too high for economic agents to be efficient
Expectedly, the equity market welcomed the cut, with the SENSEX jumping 300 points in the immediate aftermath of the policy release. The yield on the 10-year G-Sec benchmark eased a little bit, possibly because of the announcement of OMO purchases of G-Secs of Rs. 1.5 lakh crore to be held in two doses later in this month. Similarly, the US$/Rupee forward premia softened on the announcement of a 3-year buy-sell swap of US$ 5 billion slated for December 16.
Growth and Inflation Outlook
The MPC has altered the forecast of growth and inflation in this policy: real GDP growth for 2025-26 is now projected at 7.3 per cent, which is higher than 6.8 per cent that was projected in the last bi-monthly policy.
Buoyant growth numbers cannot hide the fact that both producers and consumers suffer from high real rates, which would still be above 3 per cent after the rate cut
CPI inflation for 2025-26 is now projected lower at 2.0 per cent vis-à-vis 2.6 per cent projected in the last bi-monthly meeting. Incidentally, similar alterations in growth and inflation were made in the last bi-monthly policy as well. Although there is nothing wrong in making alterations in macroeconomic forecasts in the light of new information and data, it is necessary to make sure that the forecasts do not become too adaptive. To be sure, the RBI has a robust forecasting framework, with necessary checks and balances. But a comprehensive performance review thereof is called for.
In the wake of the release of growth numbers for Q1 and Q2 of this fiscal year, a pertinent debate has ensued as to whether and to what extent the higher-than-expected growth performance, particularly in Q2 at 8.2 per cent reflects structural changes taking place in the economy, pushing outward its ‘production possibility frontier’. This debate is helpful, as it would strengthen the case for further meaningful reforms by Central and State governments, particularly in the agricultural sector. One hopes that the three farm laws which were repealed in the past under political and security considerations will be revived in some form or the other.
A weaker rupee is a tactical response to cushion external uncertainties that continue to pose downside risks to the growth outlook
In the light of the headline inflation dropping below 2 per cent as per its latest print and the continuance of high real interest rate in India, a policy rate cut was needed. Buoyant growth numbers cannot hide the fact that both producers and consumers suffer from high real rates, which would still be above 3 per cent after the rate cut.
Rate cut amid rupee depreciation
The rupee has been under significant selling pressure in recent months, linked to FPI outflows and sluggish merchandise exports growth. It slipped to an all-time low of ₹90.28 per US dollar on December 3, 2025. With a 5.3 per cent year-to-date (YTD) drop vis-à-vis US dollar, the rupee is headed for its sharpest annual decline since 2022, making it Asia’s worst-performing currency so far this year.
Is there sufficient evidence to conclude a causal link between changes in the policy rate and the headline inflation remaining within 4+/-2 per cent band?
What makes this decline particularly noticeable are the facts that the nominal index of the US dollar has declined from the high seen at the beginning of 2025 and that the current real effective rate of the rupee based on both the 40-currency and the 6-currency baskets indicate its significant undervaluation at present – a phenomenon not witnessed for a long time. On similar occasions in the past, the RBI would be reticent to slash the policy rate and also to induct sizeable durable liquidity as it intends to do now.
Hence, a feeling is gaining ground that a weaker rupee is a tactical response of the authorities to cushion external uncertainties that continue to pose downside risks to the country’s growth outlook, in general, and to mitigate the impact of headwinds being faced by merchandise exports, in particular.
Scorecard of Flexible Inflation Targeting
In the lead up to the completion of the first ten years of the flexible inflation target (FIT) framework for monetary policy formulation in India in March 2016, a formal review thereof by the RBI was announced in August this year, for the purposes of which public feedback has been sought on five questions that have been framed in this regard. The first one is “Whether headline inflation or core inflation would best guide the conduct of monetary policy, given evolving relative dynamics of food and core inflation and the continuing high weight of food in the CPI basket?”
This issue has gained importance during the last 12 months as the downward trajectory of headline CPI inflation mimicked the sharp fall in food inflation during the same period: Food inflation was 8.4 per cent in December 2024, while CPI inflation was 5.22 per cent. Ten months later, in October, 2025, headline inflation fell to 0.25 per cent, driven by a dramatic fall in food inflation to (-) 5.02 per cent. The core inflation during this period remained relatively sticky at around 3.5 per cent.
Based on these and other relevant facts, a pertinent question has been raised: is there sufficient evidence to conclude a causal link between changes in the policy rate and the headline inflation remaining within 4+/-2 per cent band? A corollary to this question is whether the FIT regime so far has been able to anchor inflationary expectations adequately. These issues need to be pursued further through rich analysis and empirical investigation.
As regards whether the tolerance band for inflation should be based on headline inflation or core inflation, all the relevant arguments favour the continuance of headline inflation. One hopes that the evaluation currently underway will strengthen the FIT framework.
