Monetary Policy, Liquidity, and the Road Hereafter

The February 2026 monetary policy outcome broadly aligned with market consensus. 

Following a cumulative repo rate reduction of 125 basis points between February and December 2025, expectations had increasingly converged around a neutral monetary policy stance, alongside a prolonged pause, as inflation was projected to inch towards the 4% target in 2026-27 after a temporary dip in 2025-26. Growth conditions, meanwhile, remained comfortable, with the economy expected to operate close to its potential growth rate of about 7%, as outlined in the 2025-26 Economic Survey, on an average basis across 2025-26 and 2026-27. Viewed through this growth-inflation lens, the prevailing Goldilocks phase warranted continuity in the policy signal to preserve the durability of macroeconomic balance.

Even so, there was an expectation in the market that the central bank might use the occasion to outline its liquidity strategy, with some participants anticipating an announcement of additional open market operation purchases after the 2026-27 Union Budget revealed a higher-than-anticipated market borrowing programme. By way of context, the Reserve Bank of India had already infused a record ₹11.7 trillion of cumulative primary liquidity during 2025-26 so far, of which 59%, 21%, and 19% had been delivered through open market operation purchases, the cash reserve ratio cut, and foreign exchange swaps, respectively. This infusion helped offset liquidity outflows arising from the Reserve Bank’s foreign exchange sale interventions, alongside organic increases in the demand for cash within the economy.

At present, headline and core liquidity appeared comfortable, at around 0.9% and 2.4% of net demand and time liabilities, respectively. Against this backdrop, there was little immediate urgency for the Reserve Bank to inject additional durable liquidity at this stage.

If the Monetary Policy Committee can be likened to the brain of the economy, liquidity functions as the nervous system that transmits signals across its vital organs. At a headline level, this nervous system appeared to be functioning as intended.

In response to the cumulative 125 basis point reduction in the policy repo rate since February 2025, we observe that:

•      The overnight interbank call money rate averaged just 7 basis points above the policy repo rate over the past three to four weeks. A broader set of overnight money market rates, including tri-party repo, market repo, and corporate bond repo, in addition to the call money rate, averaged around 20 basis points below the policy repo rate over the same period.

•      Between February and December 2025, the weighted average lending rate on fresh rupee loans declined by 105 basis points. Over the same period, the weighted average domestic term deposit rate on fresh deposits fell by 95 basis points, while the rate on outstanding deposits softened by 41 basis points.

Transmission, though, remained uneven across other segments of the financial system, particularly the term money market and the bond market, despite the cumulative easing delivered since February 2025.

•      Three-month commercial paper rates for non-bank financial companies and three-month certificate of deposit rates declined by only 70 basis points and 43 basis points, respectively.

•      The 10-year government bond yield remained broadly flat, with a similar lack of movement evident in corporate bond yields.

What explains this stark unevenness in monetary policy transmission is less straightforward. An inadequacy of liquidity is difficult to pin the blame on, given that system conditions have remained comfortable, a point underscored by the behaviour of overnight money market rates.

The bond market appeared to be discounting three interlinked concerns, in ascending order of importance.

•      Global uncertainties: The world’s largest and third-largest bond markets, the United States and Japan, were grappling with a combination of political, fiscal, and inflation-related uncertainties. The firming up of yields in these markets over the past 12 months had begun to exert a modest spillover effect on emerging market bond yields.

•      Domestic monetary policy trajectory: Assuming inflation converges towards the 4% target in 2026-27, India’s ex ante real repo rate worked out to around 1.2–1.3%, already below the long-period median of about 1.6%. Some market participants had begun to price in the possibility of a rate hike by the Monetary Policy Committee after an extended pause. Added to this was the expectation that the implementation of the Eighth Pay Commission award in 2027-28 could deliver a consumption boost of around 0.4–0.6% of GDP, potentially rekindling inflationary pressures.

•      Domestic supply concerns: The supply of general government dated securities was expected to rise to a record ₹30 trillion–₹31 trillion in 2026-27, up from about ₹26.5 trillion in 2025-26. This 15–16% expansion in gross supply will be unfolding at a time when demand from key buyers, including banks and long-only institutional investors such as insurance companies and provident and pension funds, had moderated over the past two years.

How the Reserve Bank could address these concerns warrants closer examination. The global spillover effects appear modest and could, for now, be treated as a secondary consideration. On the domestic monetary policy trajectory, the Monetary Policy Committee could continue to emphasise the neutral stance, while underscoring that both a rate cut and a rate hike remained plausible over the medium term.

The implementation of a pay commission award, by itself, need not be a sufficient trigger for inflationary pressures, as evidenced during the rollout of the Seventh Pay Commission. A combination of fiscal prudence, improvements in supply chain management, and favourable weather conditions could help mitigate any inflationary impact.

Addressing the supply overhang would require a more coordinated policy response. Reliance on open market operation purchases alone may prove insufficient, particularly if exchange rate stability following the announcement of the India–United States trade deal reduces the need for active foreign exchange sale interventions by the Reserve Bank and, by extension, the requirement for sterilisation through open market operations.

Under an assumption of a broadly stable rupee, the scope for open market operation purchases in 2026-27 appeared materially lower. On current estimates, the Reserve Bank may conduct open market operation purchases of around ₹3 trillion in 2026-27, down from about ₹6.9 trillion in 2025-26.

Policymakers could consider a mix of measures to address the prevailing supply pressures.

•      Market participants could be pleasantly surprised through the deployment of surplus cash balances for debt buybacks, as was undertaken during 2025-26.

•      Operation Twist could be deployed across both government bonds and state development loans to ease pressure on the yield curve without generating unintended liquidity spillovers.

•      Targeted regulatory adjustments for banks, insurance companies, and pension and provident funds, alongside tax incentives for mutual funds, could help raise structural demand for bonds.

Overall, it is important to clearly distinguish the sources of friction across the channels of monetary policy transmission and craft targeted responses, rather than relying on the liquidity channel to deliver an inherently imperfect fix.