Liquidity Is Plenty, Confidence Is Scarce

India’s February 2026 monetary policy review will arrive against a backdrop that looks, at least superficially, more comfortable than it did late last year. External pressures have eased, the trade overhang has reduced, and currency volatility has moderated. Yet financial conditions at home continue to tighten, exposing a disconnect that rate cuts and liquidity injections alone have failed to bridge. The constraint on monetary policy is no longer the availability of liquidity, but confidence in its usability.

By conventional metrics, the system should not be short of funds. The Reserve Bank of India has delivered a fairly deep easing cycle over the past year and backed it with substantial, durable liquidity infusion. Even so, money-market rates have drifted higher, corporate bond spreads have widened, and long-term sovereign bond yields have risen since mid-2025. These are not signals of scarcity in aggregate, but of caution in intermediation.

The behaviour of short-term funding markets has been particularly telling. The spread between certificates of deposit and the policy rate is at multi-year highs, pointing to funding stress at the margin. Banks continue to compete aggressively for wholesale deposits, even as policy rates remain well below their recent peaks. This divergence suggests that liquidity, while visible on balance sheets, is perceived as uneven, episodic, and vulnerable to drains from government cash balances, currency leakage, and foreign exchange intervention.

Transmission has been even weaker at the long end of the curve. In earlier easing cycles, long-term yields compressed quickly as markets priced lower terminal rates and improving financial conditions. This time, only a small fraction of policy easing has passed through to sovereign yields. The yield curve has flattened in a manner that reflects rising term premia rather than confidence in sustained accommodation. Corporate bond spreads have widened alongside, breaking the usual pattern seen during rate cut cycles.

This erosion of confidence has fed on itself. Market rallies have been short-lived, with investors quick to fade duration exposure amid doubts over the durability of liquidity and the willingness of banks to transmit easing. The result has been a tightening of financial conditions in practice, even as policy settings remain accommodative in intent.

Balance-sheet constraints have amplified this caution. High credit-deposit ratios have reduced banks’ room to cut lending rates meaningfully without compromising margins. Capital considerations have further limited risk appetite, particularly in longer-tenor and lower-rated credit. In this environment, liquidity injections tend to be absorbed as buffers rather than intermediated into incremental lending. What looks ample at the system level becomes scarce at the point of transmission.

The irony is that macro conditions do not demand restraint. Inflation is likely to rise as favourable base effects fade, but the trajectory appears gradual and predictable rather than disruptive. Growth remains resilient at the headline level, though private consumption and investment signals are mixed. With external risks receding, monetary policy should, in theory, have found space to work more effectively.

A pause at the February meeting would therefore be defensible on macro grounds. Yet a pause alone will not repair transmission. Markets are now focused less on the direction of the policy rate and more on the credibility of the easing framework. Without reassurance on the durability and usability of liquidity, further rate action risks becoming symbolic rather than stimulative.

What could restore confidence is not necessarily more liquidity, but clearer signals on its deployment and persistence. Greater clarity on regulatory calibration, capital flexibility, and the central bank’s tolerance for balance-sheet expansion would help markets price liquidity as reliable rather than transitory. Confidence, once impaired, is harder to inject than funds.

The February review may not be remembered for a decisive rate move. It will be judged instead on whether it acknowledges the true constraint facing monetary policy. Liquidity can be supplied by the central bank. Confidence has to be rebuilt by the system.