Market Watch: RBI Rate Cut Decision Looms Amid Growth-Inflation Tension and Forex Risks

India's economy posted a robust 8.2% year-over-year growth in Q2, driven by manufacturing expansion (4.8% y-o-y) and strong domestic demand according to the government report. This momentum comes as October inflation cooled sharply to 0.25% y-o-y, easing immediate price pressures. The Reserve Bank of India has maintained a neutral stance, but Governor Sanjay Malhotra warned that inflationary trends remain unchanged since the October meeting.

Market consensus now leans toward a 25-basis-point rate cut in December, with a 55% probability according to JPMorgan's polling as reported in financial analysis. Governor Malhotra noted that macroeconomic data supports such a move, though he stopped short of confirming it. Traders have already priced in the cut, pushing government bond yields down to 6.48%.

Yet risks persist. Muted wage growth could blunt consumption gains from easing, while the rupee's 4% annual decline against the dollar adds forex volatility. The RBI's neutral approach reflects this balance-growth is strong and inflation low, but the central bank must guard against emerging frictions.

Growth-Inflation Dilemma: When Expansion Throttles Policy Flexibility

India's latest economic engine shows impressive power, yet its speed complicates the central bank's navigation of policy waters. The Reserve Bank of India faces a dilemma: robust real GDP growth of 8.2% in Q2 remains strong even after economists revised downward its forecast for the year to a still-expansionary 7-7.5%. This growth vigor clashes with the RBI's primary mandate of price stability, as inflation remains stubbornly low at just 0.25% year-over-year in October, a point repeatedly emphasized in policy discussions.

Manufacturing, a key barometer of domestic economic health, contributed significantly to this momentum, expanding by 4.8% year-over-year in September 2025. This strength is partly mirrored in labor markets, with the labor force participation rate hitting a six-month high of 55.4% in September, suggesting broader economic activity is drawing more people into work. However, this participation surge doesn't automatically translate into wage pressure; economists note concerns about muted wage growth remaining relatively subdued, failing to ignite inflationary expectations despite the robust output and job market signals.

The combination of high growth and near-zero inflation forces a policy pause. Earlier hints from RBI Governor Sanjay Malhotra about potential easing have been overshadowed by the revised outlook and external vulnerabilities. The rupee, already at a record low of 89.6350 against the dollar, faces heightened risk of further depreciation if rates were cut, adding another layer of complexity to the central bank's decision. While domestic demand is strengthening and exports are showing resilience (up 4.84% year-to-date), the depreciating currency acts as a potential inflationary fuse if ignited.

Consequently, economists now overwhelmingly predict the RBI will hold its policy rate steady at 5.5% during its crucial December 2025 meeting, prioritizing stability over stimulus. The central bank's neutral stance reflects a cautious calculus: sustaining the accommodative environment that fuels growth while desperately guarding against any upward pressure on prices or destabilizing currency movements. The revised 7-7.5% annual growth forecast underscores that even this slightly lower figure remains exceptionally robust, leaving policymakers wary of actions that might overheat an already sizzling economy or invite capital flight through exchange rate volatility.

Liquidity and Forex: Buffer Erosion Raises Rate Cut Risks

The Reserve Bank of India's recent liquidity management is raising fresh concerns. Since February 2025, the central bank has cut the mandatory cash reserve ratio (CRR) by 100 basis points to 3%, draining liquidity from the banking system. This accommodative move coincided with lower standing facility rates, aiming to keep credit flowing even as global risks, including U.S. tariffs on Indian exports, intensified. While intended to support growth, these actions have now contributed to significant pressure on foreign exchange buffers.

India's official foreign exchange reserves shrank by $6.9 billion in late October 2024, falling to $695.36 billion. This represents the lowest level in nearly a year, though the RBI maintains the buffer remains ample, covering over 11 months of merchandise imports. The decline was driven by reductions in foreign currency assets and gold holdings. Despite this erosion, the central bank reiterated confidence in meeting all external obligations and continues targeted currency interventions to curb rupee volatility.

That confidence is now being tested. The rupee has weakened notably, approaching 89.64 per U.S. dollar. Governor Sanjay Malhotra acknowledged the possibility of a rate cut in December 2025, citing persistent inflationary pressures since the October meeting. This comment, coupled with falling bond yields, reflects market expectations of further easing. However, the RBI's focus on managing currency fluctuations rather than defending specific levels highlights the vulnerability of the current position. The 4% annual depreciation of the rupee relative to the dollar, attributed to domestic inflation gaps, adds to the pressure on reserves.

The combined effect of reduced liquidity buffers and declining forex reserves heightens the risk of financial market instability. While the RBI's 11-month import cover provides a layer of security, it is below recent peaks and leaves limited room for unexpected capital outflows or further external shocks. The Governor's opening on a potential rate cut underscores the delicate balancing act ahead-maintaining accommodative policy to support growth while preserving enough firepower to defend the currency and meet obligations.

Asymmetric Scenarios and Risk Thresholds

The Reserve Bank of India faces sharply divergent outcomes depending on its December policy decision. Economists now anticipate a hold at 5.50%, pressured by a weakening rupee that hit a record low. Should the central bank resist cuts, rupee depreciation could accelerate further to 92.00/USD, triggering significant import cost inflation. This scenario would strain households already facing weak urban income growth, while amplifying the existing -1.0% current account deficit, pushing it beyond the central bank's 4% ±2% tolerance band as noted in IMF reports.

Conversely, a rate cut would offer growth support but carries inflation risks. While October's inflation projection at 3.1% sits below the 4% ceiling, emerging wage pressures could quickly breach this tolerance if monetary easing persists. The RBI must balance this against its 6.5% GDP forecast for FY2025/26, navigating trade tensions like U.S. tariffs that complicate external demand. The central bank's tolerance for -1.0% CAD remains conditional-sustained deficits beyond the tolerance band would force policy tightening regardless of growth impulses. This asymmetric framework means the December decision will hinge on near-term rupee stability and inflation signals rather than quarterly growth data alone.