India’s inflation has moderated steadily since early 2022. By the second quarter of 2025-26, Consumer Price Index (CPI) inflation dropped to 1.9 per cent. Wholesale Price Index (WPI) inflation also declined sharply. Despite this easing, price pressures remain in certain sectors. This has raised debate on whether the Reserve Bank of India should cut interest rates further. However, a cautious approach to monetary policy is advised due to multiple underlying factors.
Recent Inflation Trends
Inflation measured by CPI fell from over 7 per cent in early 2022 to under 2 per cent by mid-2025. Food inflation turned negative recently, while non-food inflation declined more slowly. WPI inflation for consumer and non-consumer goods dropped from double digits to near zero or negative. Non-consumer goods inflation showed greater volatility and sharper moderation. The overall decline partly reflects a base effect and partly real price moderation.
Price Build-Up and Sectoral Inflation
Quarter-on-quarter inflation reveals a different picture. All four major inflation sectors—CPI food, CPI non-food, WPI consumer, and WPI non-consumer—show price build-up in Q2 2025-26. CPI food inflation build-up exceeds 10 per cent, indicating rising price pressures despite low annual inflation. This suggests inflation risk remains, warranting caution before easing monetary policy further.
Transmission of Rate Cuts
The transmission of previous repo rate cuts has largely completed. Lending rates have adjusted to lower policy rates. However, deposit rates are slower to fall due to declining current account savings and the need to align term deposit rates with administered small savings rates. This pressures bank margins but Indian banks still report relatively high net interest margins. Further rate cuts may have limited impact on borrowing costs.
Monetary Policy and Structural Inflation
India’s inflation is dominated by food prices, which monetary policy influences only weakly. Supply and demand imbalances in food markets are structural issues. Interest rate cuts have not boosted capital formation or asset acquisition. Corporate investors rely on internal funds, and MSMEs benefit from interest subvention schemes. Gross capital formation as a percentage of GDP remains stable, suggesting factors beyond interest rates guide investment decisions.
GDP Growth and Policy Coordination
India’s GDP growth recovered strongly to 7.8 per cent in Q1 2025-26, consistent with recent trends. Fiscal stimulus and tax cuts support demand. Given this, simultaneous monetary easing may not be necessary. Waiting for global economic stability before further monetary accommodation appears prudent. A dual monetary-fiscal stimulus may risk overheating or imbalances.
Credit-Deposit Growth and Liquidity
Credit growth exceeds deposit growth by about 1 per cent, a gap that could widen with rate cuts. Liquidity is comfortable following cash reserve ratio reductions. However, government expenditure, forex interventions, and rising consumption require monitoring. These factors could create excess liquidity or asset price froth if rates fall prematurely.
Inflation’s Role in Economic Health
Moderate inflation motivates investment and production. Nominal GDP growth matters for fiscal health, business planning, and expectations. Extremely low inflation or deflation can harm economic dynamism. Long-term data suggests very low implicit price deflators are unhealthy for growth.
Real Interest Rates and Neutral Policy
High real interest rates can dampen investment and consumption. However, policy decisions must consider transmission lags. Forecasts for inflation and growth indicate the neutral real policy rate remains around 1 to 1.5 per cent. Maintaining status quo in monetary policy for the near term is recommended.
Questions for UPSC:
- Critically discuss the impact of inflation targeting on monetary policy decisions in emerging economies like India.
- Analyse the relationship between food price inflation and structural supply issues in Indian agriculture.
- Examine the role of fiscal policy in complementing monetary policy for sustainable economic growth in India.
- Estimate the effects of credit-deposit growth mismatch on banking sector stability and economic liquidity management.
Answer Hints:
1. Critically discuss the impact of inflation targeting on monetary policy decisions in emerging economies like India.
- Inflation targeting sets explicit inflation goals to anchor expectations and guide policy.
- Helps maintain price stability, which is crucial for economic growth and investment confidence.
- In India, CPI inflation targeting mandates keeping inflation within a specified band (e.g., 4% ± 2%).
- Challenges include supply-side shocks (e.g., food inflation) that monetary policy cannot easily control.
- Base effects and sectoral price build-ups can mislead policy if only year-on-year inflation is considered.
- Strict inflation targeting may limit monetary policy flexibility during growth slowdowns or external shocks.
2. Analyse the relationship between food price inflation and structural supply issues in Indian agriculture.
- Food inflation in India is largely driven by supply-demand imbalances rather than monetary factors.
- Structural issues include fragmented landholdings, inadequate storage, and inefficient supply chains.
- Seasonal variability, monsoon dependency, and perishability exacerbate price volatility.
- Government interventions like MSP, subsidies, and buffer stocks impact food prices but may distort markets.
- Monetary policy has limited influence on food inflation due to its structural nature.
- Addressing supply-side constraints is essential for sustainable control of food price inflation.
3. Examine the role of fiscal policy in complementing monetary policy for sustainable economic growth in India.
- Fiscal policy through government spending and taxation directly influences aggregate demand and growth.
- Fiscal stimulus (e.g., post-GST rate cuts) supports consumption and investment alongside monetary measures.
- Coordinated fiscal-monetary policy avoids overheating and inflationary pressures.
- Fiscal discipline ensures sustainable debt levels, maintaining macroeconomic stability.
- Targeted fiscal measures (infrastructure, subsidies) can address structural bottlenecks monetary policy cannot.
- Dual triggers (fiscal and monetary easing) should be carefully timed to avoid macroeconomic imbalances.
4. Estimate the effects of credit-deposit growth mismatch on banking sector stability and economic liquidity management.
- A persistent credit growth exceeding deposit growth widens the credit-deposit gap, pressuring bank liquidity.
- Banks may rely on costly borrowings or reduce lending, affecting profitability and credit availability.
- Liquidity surplus or deficit impacts interest rates, monetary transmission, and financial stability.
- In India, comfortable liquidity post-CRR cuts reduces immediate risks but requires monitoring government expenditure and forex interventions.
- Widening gaps can lead to asset price bubbles or credit risks if unchecked.
- Prudent monetary policy and regulatory oversight are needed to maintain balance and stability.
