RBI policy: Goldilocks, FX, and the Windscreen

While monetary policy is backed by science, monetary policymaking is an art. The RBI’s Monetary Policy Committee is a living testament to this maxim. Faced with the policy conundrum of a healthy growth print and subdued inflation — a state which the RBI Governor Malhotra aptly described as a “rare Goldilocks period” in India’s post-COVID economic phase — the MPC, displaying its commitment to the mandated script of flexible inflation targeting, delivered a 25-bps cut in the repo rate.

As anticipated by many in the market, this was going to be a close call. On one hand, CPI inflation slipping below the 2% level (July-September printed at 1.7% while October 2025 slipped further to 0.25%), the threshold of policy tolerance, made a clear case for incremental monetary policy easing.

On the other hand, a few factors perhaps warranted caution. 

• Following its recent low of 5.6% in July-September 2024-25, GDP growth has been picking up momentum quarter by quarter. The last available print shows a robust performance of 8.2% growth in the second quarter of 2025-26. This is noteworthy as India’s growth momentum has improved substantially, defying the widespread belief that the current adverse geoeconomic and geopolitical headwinds would pose a serious setback.
• Having said that, the external headwinds did arise elsewhere. The rupee has been one of the worst-performing major currencies in the world this year. Amidst the backdrop of the US tariff turbulence and record-high prices of precious metals, the rupee fell below the psychological level of 90 to the dollar on the very first day of the MPC review meeting¹. The weakness in the currency is now becoming noticeable from a change perspective as well – the annualised depreciation in the rupee is currently tracking ~6% levels, twice its long-term (last 25 years) average of ~3%. As per RBI’s empirical estimates, a 5% depreciation in the rupee imparts 35 bps of upside to CPI inflation, with some lag.

This is not the first time that the RBI faced this policy dilemma. Analysis of past rate cut episodes (under the current inflation targeting regime, excluding the COVID response) suggests:

• While inflation has generally been the most influential variable in influencing the rate cut decision, the MPC has in the past also shown responsiveness to growth concerns as well.
• Having said that, there are now four quarterly instances of rate reduction characterised by GDP growth in excess of 7% accompanied by below target CPI inflation. Notably, three out of four such quarterly instances have happened in 2025 (Chart 1).

The monetary policy reaction function to currency movement is not uniform either (Chart 2). Past episodes of rate cuts (since 2002, excluding the GFC and COVID period responses) have happened at times when rupee has, on average, depicted an annualised depreciation of 3.4%². However, there is enough evidence of the RBI opting for a rate cut when the annualised depreciation in rupee exceeded its long-term trend.

Chart 1: Growth-inflation balance and monetary policy easing

 

Note: (i) The quarters depict the period of rate cuts by the MPC since the current form of inflation targeting became applicable, (ii) the size of the bubble corresponds to the magnitude of the rate cut, (iii) dark blue shade denotes a ‘Goldilocks’ economic state. Source: CEIC, RBI, and QuantEco Research

Chart 2: Monetary policy easing amidst a change in the Rupee

Note: The period covers all rate cuts from 2002, excluding the RBI response during the GFC (2008) and the COVID (2020) periods. Source: CEIC, RBI, and QuantEco Research

So clearly, the growth-inflation balance and the currency performance have not acted as a singular binding factor for influencing the monetary policy decisions of the RBI. Broader financial and credit market conditions, sentiment of economic stakeholders, assessment of unobserved variables like real interest rates and output gap, and last, but not least, the forward-looking economic compass play an equally important role (Chart 3).

In this context, we note that the central bank is forecasting a moderation in GDP growth momentum towards 6.8% on an average basis over the next 4 quarters compared to the current realised momentum of 7.4% (on 4 4-quarter average basis). On similar lines, the smoothened CPI inflation trajectory also shows a projected moderation towards 2.9% over the next 4 quarters compared to the current realised momentum of 3.4% (on 4 4-quarter average basis).

Chart 3: Over the next 4 quarters, RBI projects moderation in GDP growth momentum even as CPI inflation is projected to remain benign  

Note: Bold line is the realised trajectory, while the dotted line shows the projected trajectory derived from the RBI’s forecasts provided in Dec-25. Source: CEIC, RBI, and QuantEco Research

This divergence between the rear-view mirror (what has been realised) and the windscreen view (forward-looking estimates) appears to have formed the basis for the rate cut in December 2025. In this assessment, while the rupee has played the role of a minor irritant, policymakers believe that its inflation-inducing impact could be offset by the GST rationalisation. Meanwhile, the RBI stands ready to confront the adverse spillover impact of rupee depreciation on financial and credit markets by sterilising its recent FX intervention via provision of ₹1.5 trillion durable liquidity in the form of bond purchases and FX swaps. Provision of durable liquidity would help reinforce the MPC’s rate cut decision.

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1 The MPC usually meets over three days. The meeting in December 2025 commenced on the 3^rd, the same day when dollar/rupee breached 90 for the first time.
2 This is close to the long-term trend depreciation of rupee at around 3%.