The MPC has changed the growth and inflation forecast in this policy | Photo credit: SUSHIL KUMAR VERMA
The stock market was expected to welcome the cut, with the Sensex rising 300 points in the immediate aftermath of the policy release. The yield on the 10-year G-Sec benchmark fell slightly, possibly due to the announcement of OMO purchases of G-Secs worth ₹1.5 lakh crore, which will be held in two doses later this month. Similarly, dollar-rupee forward premiums fell following the announcement of a three-year $5 billion buy-sell swap scheduled for December 16.
Growth and inflation prospects
The MPC has changed the growth and inflation forecast in this policy, with real GDP growth for 2025-2026 now projected at 7.3 percent, higher than the 6.8 percent forecast in the last bi-monthly policy.
CPI inflation for 2025-2026 is now projected lower at 2 percent vis a vis 2.6 percent forecast at the last bimonthly meeting. Incidentally, similar changes in growth and inflation were also implemented in the last bi-monthly policy. While there is nothing wrong with changing macroeconomic forecasts in light of new information and data, it is necessary to ensure that forecasts do not become too adaptive. Certainly, the RBI has a robust forecasting framework, with the necessary checks and balances. But a comprehensive performance assessment thereof is needed.
In the wake of the release of the growth figures for the first and second quarters of this fiscal year, a relevant debate has emerged on whether and to what extent the higher-than-expected growth performance, especially in the second quarter of 8.2 percent, reflects structural changes taking place in the economy, pushing the ‘production possibilities frontier’. This debate is useful as it would strengthen the case for further meaningful reforms by central and state governments, especially in the agricultural sector. It is hoped that the three farm laws, which were repealed in the past on political and security grounds, will be revived somehow.
In light of inflation, which has fallen below 2 percent according to the latest publication, and the persistently high real interest rates in India, a reduction in the policy rate was necessary. Exuberant growth figures cannot disguise the fact that both producers and consumers are faced with high real interest rates, which would still be above 3 percent after the interest rate cut.
Interest rate cut due to rupee depreciation
The rupee has been under significant selling pressure in recent months due to FPI outflows and sluggish growth in merchandise exports. The rate fell to an all-time low of ₹90.28 per US dollar on December 3. With a decline of 5.3 percent year-to-date (YTD). vis a vis The US dollar, the rupee, is on track for its sharpest annual decline since 2022, making it Asia’s worst-performing currency so far this year. What makes this decline particularly striking are the facts that the nominal index of the US dollar has fallen from its early 2025 high and the current real effective rate of the rupee, based on both the 40-currency basket and the 6-currency basket, points to its significant undervaluation at this point in time – a phenomenon we have not seen for a long time.
On similar occasions in the past, the RBI would have been reluctant to cut the policy rate and infuse significant sustainable liquidity, as it now plans to do. Therefore, the feeling is gaining ground that a weaker rupee is a tactical response by the authorities to address external uncertainties that continue to pose downside risks to the country’s growth prospects in general, and to cushion the impact of the headwinds facing goods exports in particular.
FIT scorecard
In the run-up to the completion of the first ten years of the flexible inflation targeting (FIT) framework for monetary policy formulation in India in March 2016, a formal review of the same was announced by the RBI in August this year, with an aim of seeking public feedback on five questions formulated in this regard.
The first is: “Whether headline inflation or core inflation would best guide the conduct of monetary policy, given the changing relative dynamics of food and core inflation and the continued high weight of food in the CPI basket?” This issue has gained importance over the past twelve months as the downward trajectory of headline CPI inflation mimicked the sharp decline in food inflation over the same period: food inflation stood at 8.4 percent in December 2024, while CPI inflation stood at 5.22 percent.
Ten months later, in October 2025, headline inflation fell to 0.25 percent, driven by a dramatic fall in food inflation to (-) 5.02 percent. Core inflation remained relatively stable at around 3.5 percent during this period. Based on these and other relevant facts, a pertinent question has arisen: is there sufficient evidence to conclude a causal relationship between changes in the policy rate and headline inflation remaining within the 4+/-2 percent range?
A corollary to this question is whether the FIT regime has so far succeeded in adequately anchoring inflation expectations. These issues need to be further explored through rich analyzes and empirical research. As to whether the margin of tolerance for inflation should be based on headline inflation or on core inflation, all relevant arguments favor the continuation of headline inflation. It is hoped that the currently ongoing evaluation will strengthen the FIT framework.
The writer is a former central banker and advisor to the IMF) (Through The Billion Press)
Published on December 8, 2025
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