RBI’s December Dilemma: When Growth Meets Liquidity

 RBI’s December Dilemma: When Growth Meets Liquidity 

R Kannan

The air surrounding the December 2025 Monetary Policy Committee (MPC) meeting of the Reserve Bank of India (RBI) is thick with anticipation . On the surface, the Indian economy presents a picture of enviable strength: Q2-FY26 GDP growth has dramatically outpaced forecasts, proving the resilience and underlying momentum of domestic demand. Simultaneously, the success of the Flexible Inflation Targeting (FIT) framework is evident, with the Consumer Price Index (CPI) showing a steady downward trajectory and hovering at its historical low. This combination of high growth and low inflation has fuelled a widespread, almost consensus, demand from industry for a substantial interest rate cut.

However, the duty of a central banker is to manage risks. For the RBI, the apparent "Goldilocks" scenario is complicated by three critical factors lurking beneath the surface: strained banking system liquidity, persistent Rupee depreciation against the dollar, and the narrowing interest rate differential with the US. These constraints force the RBI to confront a fundamental policy choice: Could it pursue the growth opportunity presented by low inflation, or could it prioritize the financial stability threatened by capital flight and domestic funding tightness? A singular rate cut, while politically popular, risks destabilizing the progress made. The solution lies not in one lever, but in the sophisticated and differentiated deployment of the entire policy toolkit.

The Alluring Case for Rate Accommodation

The primary argument for a repo rate reduction is compellingly simple: the macroeconomic stability triangle—Growth, Inflation, and Fiscal Prudence—appears well-balanced. With CPI comfortably below the 4% target and trending lower, the RBI has successfully anchored inflation expectations, providing the nominal policy space required for accommodative action.

A rate cut would serve several vital functions:

• Lowering the Cost of Capital: By reducing the policy rate, the RBI lowers the marginal cost of funds for banks, encouraging them to pass on cheaper lending rates to corporations and consumers. This is crucial for translating strong GDP momentum into higher corporate investment, specifically in capacity expansion, which has lagged in recent years.
• Boosting Consumption and Housing: Lower EMIs would provide relief to existing borrowers and stimulate demand for consumption durables and, critically, the beleaguered real estate sector. This feeds back into a virtuous cycle of demand-led growth.
• Sustaining Previous Measures: It would logically complete the growth-boosting policy narrative established in the previous MPC meeting, affirming the central bank’s commitment to supporting the economy’s expansion phase.

To resist the temptation of a rate cut in this inflation environment requires an iron will and a clear understanding of the financial plumbing, which is currently emitting distress signals.

The Critical Constraints: Stability Over Signals

The ultimate goal of the RBI is not merely growth, but sustained, stable growth. The current environment possesses three deep-seated fragilities that a rate cut would immediately and severely aggravate, demonstrating a failure of pragmatic central bank practice:

1. The Banking Liquidity Crisis: A Bottleneck to Credit Transmission

The most pressing domestic concern is the status of the banking system. The data is clear: liquidity in the banking system is at a low level. While bank credit growth remains healthy at approximately 10%, bank deposit growth is also hovering at this mark. This near-equal growth indicates a fundamental tightness in the system—banks are lending almost as fast as they are garnering deposits, leaving little surplus for further expansion.

A rate cut now would be ineffective and potentially counterproductive.

• Ineffective Transmission: Banks facing liquidity shortages will not pass on the full policy rate cut. They may keep their lending rates elevated to preserve margins and attract scarce deposits, leading to a disconnect between the policy signal and its real-world impact.
• Disincentivizing Deposits: A cut would further lower deposit rates. In a high-growth environment, households and corporations are already seeking higher returns elsewhere (equities, bonds). Reducing deposit returns would widen this gap, slowing the pace of deposit mobilization and starving banks of the necessary funding base to support the current 10% credit growth. This risks an internal, self-inflicted credit crunch.

2. The Rupee and the Narrowing Differential

Externally, the situation demands extreme caution. The Rupee has depreciated against the dollar by close to 5%—a significant movement that pressures corporate import costs and raises inflation risk. This depreciation is exacerbated by the narrowing interest rate differential between the US and India.

• Capital Outflow Risk: As the differential shrinks, the risk-adjusted return for Foreign Institutional Investors (FIIs) holding Indian debt diminishes. This incentivises capital flight—the repatriation of funds to higher-yielding US assets or other emerging markets.
• Best Practice Counter-Cyclical Policy: A core central bank best practice in managing capital account volatility is to maintain an adequate interest rate premium, particularly when external factors (like persistent punitive import tariffs by the USA) are already creating trade imbalances. A rate cut would be a direct signal to FIIs that the premium is evaporating, accelerating capital outflows and compounding the pressure on the Rupee. The RBI can use its interest rate as a tool to maintain currency stability, which is vital for long-term growth and confidence.

The Policy Prescription: Differentiated Tool Deployment

The RBI cannot afford a 'one-size-fits-all' policy. To secure growth, liquidity, and currency stability simultaneously, the MPC can employ a strategy of differentiated tool deployment, separating the policy rate from liquidity management:

I. Interest Rate Decision: A Strategic PAUSE

The MPC can hold the Repo Rate unchanged at its current level.

This move is not hawkish; it is strategically stabilizing. It sends a clear, unambiguous signal to global investors that the RBI is prioritizing currency stability and prudent financial risk management over a short-term political dividend. This pause acts as a necessary anchor for the Rupee, helps to re-widen the interest rate differential, and buys the economy time until the global interest rate environment, particularly the US Fed's stance, becomes clearer. The MPC can communicate this pause as a "stability measure" that enables future growth, not as a tightening of the monetary cycle.

II. Liquidity Management: Aggressive Easing

Since the problem is liquidity, the solution can be liquidity. To address the tightness and support the domestic credit transmission without cutting the repo rate, the RBI can aggressively and transparently use its non-rate tools:

1. Operation Buy: Durable Liquidity Injection (OMO): The RBI could announce a calendar for significant Open Market Operations (OMOs) to purchase Government Securities (G-Secs). This action directly injects durable, high-powered money into the banking system, immediately alleviating the low liquidity status. This is the most effective way to give banks the reserves they need to sustain credit growth without placing downward pressure on the policy rate or deposit rates.
2. Long-Term Repo Operations (LTROs): To encourage term lending and confidence, the RBI could announce targeted LTROs at a rate linked to the policy rate. This would provide banks with stable, long-term funds to confidently underwrite long-duration projects, such as infrastructure and industrial CAPEX, which are essential for sustained growth.
3. Refining the Cash Reserve Ratio (CRR): While a blunt instrument, the RBI could consider a marginal, symbolic reduction in the CRR. This action directly frees up locked reserves, offering immediate, system-wide liquidity relief and reinforcing the message that the central bank's stance on domestic funding remains highly accommodative, even if the policy rate is on pause.

The Long-Term Imperative: Financial Stability as the Growth Bedrock

The December 2025 MPC meeting is a test  for RBI. The greatest risk to India’s high-growth narrative is not a minor deviation from the inflation target, but a full-blown financial stability event triggered by capital flight or a domestic credit seizure.

By holding the repo rate, the RBI protects the external account and manages capital flows. By simultaneously easing liquidity through OMOs and other term tools, it supports the domestic credit cycle and validates the strong GDP growth. This differentiated approach, which is the hallmark of modern, sophisticated central bank practice in open economies, ensures that the strong growth of Q2-FY26 is not a fleeting peak, but a stable, well-funded platform for India’s ascent into the next fiscal year. The correct policy is one that prioritizes stability today for sustained growth tomorrow.

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