The US Might De-anchor.....

 The Federal Reserve operates under a dual mandate from Congress: to achieve maximum employment and maintain price stability, the latter being defined by the Fed's 2% annual inflation target. Central bank credibility is crucial, as it anchors market and public inflation expectations. When the public trusts the Fed to keep prices stable, their expectations for future inflation remain low and stable, which in turn helps the Fed achieve its goals with less economic disruption. The current scenario presents a conflict: inflation is above target, but potential economic slowdowns due to trade frictions (tariffs) might argue for stimulus (rate cuts).

The Impact on Credibility

Cutting rates in this environment would likely have several negative impacts on the Fed's credibility:

Signals a De-prioritization of Price Stability: The fundamental monetary policy theory states that raising rates combats inflation by making borrowing more expensive and slowing economic activity. Cutting rates when inflation is above target suggests the Fed is willing to tolerate higher inflation, directly contradicting its commitment to the 2% target.

Risks Unanchoring Inflation Expectations: If markets perceive the Fed is not committed to fighting inflation, they may raise their own inflation expectations. This can lead to a self-fulfilling prophecy, where businesses and consumers act on these higher expectations (e.g., demanding higher wages, raising prices), potentially embedding persistent inflation into the economy.

Perception of Political Influence: The scenario mentions tariff frictions, which often involve political dimensions. If the executive branch is pushing for rate cuts (a recurring theme in recent history, such as during the Trump administration) and the Fed complies despite data suggesting otherwise, it could be seen as caving to political pressure, compromising its independence and, consequently, its credibility.

Internal Dissent as a Signal: High levels of dissent within the Federal Open Market Committee (FOMC), the Fed's decision-making body, would underscore the lack of a unified front and further undermine public confidence.

Examples and Data

Historical Parallel (Hypothetical from recent news): In late 2024 and 2025, when inflation was slightly above target (e.g., consumer prices rising 2.9% year-over-year, 0.9% above the 2% target), the Fed did consider rate cuts to mitigate the economic risks from ongoing tariff wars. Some officials argued forcefully against cuts, stating "inflation is too hot". The resulting dissent (a 9-3 vote in one instance) highlighted the internal conflict and the risk to credibility.

Market Data: When the market is nervous about persistent inflation, it demands higher yields on long-term bonds to compensate for the potential erosion of returns. If the Fed cuts short-term rates but long-term bond yields remain high or rise, it signals the bond market's skepticism about the Fed's ability to manage long-term inflation, a direct reflection of weakened credibility.

A decision to cut interest rates with inflation at 3% amid trade tensions would likely be interpreted as the Fed prioritizing short-term economic stimulation (addressing potential job losses from tariffs) over its core mandate of price stability. While tariffs can have a complex, two-sided effect on the economy, potentially leading to both an initial slowdown (negative demand shock) and later cost-push inflation, cutting rates would primarily fuel the latter. The move would risk unanchoring inflation expectations and lead to a significant loss of credibility, making it much harder for the Fed to control prices in the future and potentially resulting in a more painful economic adjustment down the line. A Federal Reserve (Fed) interest rate cut when inflation is 1% over the 2% target (meaning inflation is at 3%) and amid tariff frictions would significantly undermine its credibility. The action would conflict with the Fed's primary mandate of price stability and could lead markets to believe the central bank is prioritizing other factors (like employment or political pressure) over its stated inflation target. 

The Dual Mandate and Policy Signals.....

Central banks manage a delicate balance between controlling inflation (price stability) and fostering economic growth (output stability). The RBI communicates its future intentions to the market through its policy "stance" (accommodative, neutral, or tightening) and its operational tools (like the repo rate, CRR, and OMOs). Clarity in communication is crucial for market participants (businesses, investors, borrowers, and savers) to form accurate expectations, which in turn influence their economic decisions. A neutral stance suggests flexibility and data dependency, while operational liquidity measures have a direct, tangible impact on money supply and interest rates.

The Confusion in Market Expectations

The conflict between a neutral stance and expansionary liquidity measures creates market confusion in several key ways:

Mixed Signals on Future Rate Trajectory: A neutral stance implies that a rate hike or a rate cut is equally possible, depending on incoming data. However, announcing OMO purchases (which inject liquidity) or hinting at CRR reductions (which free up bank funds for lending) are essentially expansionary actions that the market interprets as a prelude to rate cuts (an accommodative bias). This disparity in signal makes it difficult for market participants to confidently predict the direction of future interest rates.

Uncertainty Over Policy Priority: The market is left guessing whether the RBI's primary concern is inflation or growth. The official neutral stance suggests a balanced view, but actions that increase the money supply are generally aimed at stimulating a slowing economy. This ambiguity leads to divergent interpretations and hinders the formation of a unified market consensus on the central bank's actual priority.

Challenge in Pricing Financial Instruments: Financial markets price assets based on expectations of future interest rates and economic conditions. When the RBI's stance (communication) and actions (liquidity management) seem misaligned, it increases volatility and makes it difficult for banks and investors to price loans, bonds, and other financial instruments accurately. For instance, bond yields might initially react to the OMOs (expecting lower future rates) but remain volatile due to the uncertainty implied by the "neutral" label.

Recent Examples and Data

A key example of this dynamic occurred during the RBI's December 2025 monetary policy review:

Policy Stance and Rate Action: The RBI's Monetary Policy Committee (MPC) cut the repo rate by 25 basis points to 5.25% while maintaining a neutral stance.

Liquidity Measures: Concurrently, the RBI announced a commitment to purchase government bonds worth up to ₹1 lakh crore through OMOs and a $5 billion buy-sell swap to inject liquidity and stabilize currency markets.

Market Reaction and Confusion:

The market initially reacted enthusiastically to the rate cut and liquidity infusion, pushing up equity markets and leading to expectations of further easing (a "dovish" interpretation).

However, the retention of the "neutral" stance, despite the rate cut and OMOs, led some economists to caution that the extent of future easing might be limited and data-dependent, rather than the start of a prolonged cutting cycle.

The MPC also revised the CPI inflation forecast for FY26 to a low of 2% but noted ongoing risks from global factors. This created a perception that the RBI was aggressively focused on growth, which contrasted with the cautious, balanced signaling of a neutral stance.

The Reserve Bank of India's (RBI) simultaneous pursuit of a 'neutral' monetary policy stance while actively injecting liquidity through tools like the Cash Reserve Ratio (CRR) and Open Market Operations (OMOs) can confuse the market by sending mixed signals about its future intentions. A neutral stance typically implies a data-dependent, "wait-and-watch" approach with no inherent bias toward easing or tightening, but liquidity injections are a form of de facto easing, creating uncertainty about the RBI's true commitment to either growth or inflation control. Clear and consistent central bank communication is paramount for stable market expectations and efficient policy transmission. When the RBI pairs a "neutral" policy stance with actions that strongly lean towards monetary easing, it creates a communication gap. This results in market uncertainty as participants attempt to reconcile the stated "neutrality" with the operational "accommodation". To minimize confusion, the RBI could ensure its forward guidance and liquidity management tools are more explicitly aligned, providing a unified message about its short-term priorities and long-term commitment to its flexible inflation targeting framework.

The Role of Credibility and Expectations in Monetary Policy.....

Monetary policy operates with a significant lag, meaning today's interest rate decision affects inflation several quarters in the future. Therefore, a central bank's ability to achieve price stability and support growth depends heavily on its credibility and how effectively it can anchor the public's expectations of future inflation. When the public forms "rational expectations" and aligns its decisions with the RBI's transparent forecasts, the intended policy outcomes are achieved more smoothly, without significant disruptions to real economic activity.

Effects on Prices

If people believe the RBI's inflation projections, the primary effect on prices is increased stability and reduced volatility.

Anchoring of Expectations: Credible RBI projections act as a nominal anchor for the economy. Businesses are less likely to raise prices speculatively, and workers are less likely to demand excessive wage increases if they are confident that future inflation will remain low and stable, within the RBI's target band of 4% (±2%).

Preventing Wage-Price Spirals: In a high-inflation scenario, workers often demand higher wages to compensate for the rising cost of living, which in turn increases business costs and leads to further price hikes, creating a spiral. If the public believes the RBI will successfully curb inflation, these second-round effects are mitigated, and wage and price adjustments remain moderate.

Efficient Price Setting: Firms can make more informed pricing decisions with less uncertainty about future costs and demand conditions, leading to more efficient markets and less price volatility.

Effects on Growth

Stable inflation expectations provide a conducive environment for sustainable economic growth.

Lower Interest Rates and Investment: Anchored inflation allows the RBI more policy space to keep interest rates lower for longer, or to cut rates when needed to stimulate the economy, without immediately triggering fears of runaway inflation. Lower borrowing costs encourage businesses to invest in new projects and individuals to make big-ticket purchases (e.g., homes, vehicles), boosting aggregate demand.

Reduced Uncertainty: Predictable prices reduce uncertainty for investors and consumers, encouraging long-term planning, savings, and investment. This fosters a stable macroeconomic environment essential for sustained growth.

Supportive Policy Mix: When the public trusts the RBI's commitment to price stability, it provides cover for coordinated fiscal and monetary policy support for growth, as seen in recent Indian economic outcomes.

Recent Data and Examples from India

The recent period in India provides a clear example of this dynamic at play.

Inflation Moderation (2025): India's retail inflation (CPI) has generally remained within or below the RBI's target band in 2025, falling to a record low of 0.25% in October 2025, largely due to easing food prices and timely government supply-side interventions.

RBI Action and Credibility: In response to the benign inflation outlook, the RBI's Monetary Policy Committee (MPC) revised its inflation projection for FY2025-26 downwards to 2% and, in a significant move, upgraded the GDP growth forecast for the same fiscal year to 7.3%. The subsequent decision to cut the policy repo rate was met with market anticipation, as analysts expected the downward revision, demonstrating high central bank credibility.

Positive Feedback Loop: The actual moderation of inflation reinforced public confidence in the RBI's projections and policy framework. This "goldilocks period" of robust growth and benign inflation has been supported by positive expectations, leading to an uptick in non-food bank credit, rising consumer confidence, and increased private investment, all contributing to stronger GDP growth.

When individuals and businesses in India believe and act upon the Reserve Bank of India's (RBI) inflation projections, it significantly enhances the effectiveness of monetary policy, leading to greater price stability and more stable economic growth. This mechanism, rooted in the theory of rational expectations, helps to prevent volatile price and wage spirals and allows the RBI greater flexibility to manage short-term economic shocks. When the public forms decisions based on the RBI's inflation projections, a virtuous cycle is created: the central bank's communication becomes a powerful tool, guiding private sector behavior toward price stability. This collective belief and action in alignment with the RBI's goals helps in anchoring inflation expectations, suppressing volatile wage and price dynamics, and ultimately provides the stable, low-inflation environment necessary for vigorous and sustainable economic growth. The recent Indian experience highlights how strong central bank credibility translates into tangible positive macroeconomic outcomes.

The Power of Expectations.....

 In modern macroeconomics, expectations are not passive predictions; they are active drivers of economic behavior. The theory of rational expectations posits that individuals, businesses, and investors use all available information, including past experiences and current policy announcements, to form the most accurate possible forecasts about the future. A self-fulfilling expectation occurs when an expectation, simply by existing and influencing behavior, causes the predicted event to happen. When economic actors rationally expect the RBI's inflation projection to be accurate, they make decisions (e.g., wage setting, pricing, investment) that align with that forecast, effectively making it a reality.

Dynamics of Economic Growth Under Self-Fulfilling Expectations

If everyone expects the RBI's inflation projection to be accurate and acts rationally, the following dynamics emerge:

Anchored Inflation: The primary dynamic is that inflation expectations become firmly anchored to the RBI's stated target (currently a band of 4% +/- 2%). If the RBI projects inflation will be, for example, 4.5% for the next quarter, businesses set prices and negotiate wages based on this figure, preventing a disruptive wage-price spiral.

Credible Monetary Policy: The RBI gains significant credibility. Its policy announcements are believed and acted upon, enhancing its ability to manage the economy effectively. This credibility is a valuable asset, allowing the central bank to influence economic conditions with minimal actual intervention.

Stable Planning Environment: A predictable inflation environment reduces uncertainty for economic agents.

Businesses can make long-term investment decisions with greater confidence in future costs and revenues, leading to increased capital formation and economic expansion.

Households can better plan their savings and consumption, as the purchasing power of their money is expected to remain relatively stable over time.

Effective Policy Transmission: Monetary policy actions (like adjusting interest rates) have their intended effects more smoothly. If the RBI raises interest rates to curb perceived inflationary pressures, rational agents who expect inflation to fall as a result will adjust their spending and borrowing behavior, reinforcing the policy's effect.

Sustained Economic Growth: The stability derived from anchored expectations creates a favorable environment for sustainable, long-term economic growth. By minimizing the "noise" of volatile inflation, the economy can operate closer to its potential output level, avoiding the disruptions caused by unexpected price shocks.

Example

Assume the RBI announces an inflation projection of 4% for the upcoming fiscal year.

Rational Behavior:

A labor union, believing the RBI, agrees to a wage increase of 4% for its members, seeking to maintain real purchasing power.

A business owner, expecting input costs to rise by only 4%, decides to invest in new machinery and raises product prices by a similar margin.

A lender sets interest rates on loans based on the expected 4% inflation rate plus a real return margin.

Self-Fulfilling Outcome:

Because wages and prices across the economy largely align with the 4% expectation, the actual inflation rate for the year ends up being close to 4%. The collective rational actions validated the initial projection.

Growth Dynamics:

Since the inflation was predictable and moderate, the real economy experiences a "goldilocks" period of stable prices and robust growth, as businesses and households enjoy certainty and act efficiently.

The dynamic of economic growth under rational, self-fulfilling expectations related to the Reserve Bank of India's (RBI) inflation projections is a powerful illustration of how monetary policy credibility can directly influence real economic outcomes. When the public trusts and acts upon the RBI's forecasts, their collective behavior can validate the central bank's projections, leading to a more stable and predictable economic environment, which in turn fosters sustainable growth. When economic actors form rational expectations based on the RBI's projections, a virtuous cycle of credibility and stability emerges. This scenario largely neutralizes unexpected inflation as a source of economic distortion, allowing monetary policy to effectively anchor prices and provide a solid foundation for sustainable economic growth. The power of self-fulfilling expectations in this context underscores the critical importance of central bank transparency, clear communication, and consistent policy to build and maintain public trust.

The MPC Reduced The Repo Rate To 5.25% And Maintained A "Neutral" Stance......

 In its latest monetary policy review on December 5, 2025, the Reserve Bank of India (RBI) delivered a significant policy shift by cutting the benchmark repo rate by 25 basis points (bps) to 5.25%. This move was a response to a "rare Goldilocks period" for the Indian economy, characterized by surprisingly strong growth momentum and rapidly easing inflation, which provided the necessary policy space for an accommodative action. The decision, reached unanimously by the Monetary Policy Committee (MPC), aims to stimulate credit demand and reinforce the domestic growth trajectory amid a volatile global economic landscape.

RBI Commentary on Rate Cut and Economic Prospects

RBI Governor Sanjay Malhotra highlighted that the current economic environment supports a pro-growth, pro-liquidity policy. The key highlights of the commentary are:

Repo Rate Cut and Stance: The MPC reduced the repo rate to 5.25% and maintained a "neutral" stance. This neutral stance indicates the central bank's flexibility to adjust rates in either direction based on future data, though the current action is decidedly aimed at boosting consumption and investment.

Strong Growth Projections: The RBI substantially upgraded its real GDP growth forecast for FY2025-26 to 7.3%, a significant increase from its previous 6.8% projection. This optimism is underpinned by strong Q2 GDP growth of 8.2%, resilient domestic demand, healthy agricultural prospects, and the positive effects of GST rationalization.

Benign Inflation Outlook: The central bank lowered its CPI inflation forecast for FY2025-26 to a low of 2%, down from the 2.6% projected earlier. This downward revision reflects a "faster-than-anticipated decline" in price pressures, particularly in food prices, which fell contrary to seasonal trends in September and October.

Liquidity Measures: To ensure effective transmission of the rate cut and maintain orderly financial conditions, the RBI announced additional liquidity support measures, including Open Market Operation (OMO) purchases of government securities worth ₹1 lakh crore and a three-year dollar-rupee swap of $5 billion.

Impact on Supply and Price Expectations

The RBI's policy decisions are expected to have a significant effect on supply and price dynamics in the Indian economy:

Price Expectations (Inflation)

Moderated Price Pressures: The rate cut is a signal of the RBI's confidence that inflation will remain within its target band of 2-4% for the foreseeable future. The Governor noted that the decline in inflation has become "more generalised," with core inflation also moderating to 2.6% in October.

Anchored Expectations: By proactively cutting rates when inflation is low, the RBI aims to keep future price expectations anchored at a benign level. The forecasts suggest that inflation will remain below 4% in the first half of FY2026-27.

Supply Expectations

Increased Credit Flow: A lower repo rate reduces the cost of funds for banks, encouraging them to offer cheaper loans for households (home, auto, personal) and businesses (working capital, investment). This is expected to spur credit growth and boost overall consumption and private investment, thereby stimulating economic activity.

Support for Key Sectors: Sectors like real estate and MSMEs are expected to benefit significantly from lower borrowing costs, which can encourage new projects and job creation, supporting a virtuous cycle of growth and supply.

Optimistic Supply Prospects: The commentary mentioned improved food supply prospects due to higher kharif production and healthy rabi sowing, which are expected to keep food price volatility in check and aid overall supply stability.

The RBI's decision to cut the repo rate to 5.25% in December 2025 is a strategic, growth-oriented move, leveraging the available policy space created by a sustained period of low inflation and robust GDP performance. The commentary projects a positive wider economic outlook, with higher growth and lower inflation forecasts. By making credit cheaper and ensuring ample liquidity, the RBI aims to bolster demand, stimulate investment, and reinforce the supply chains, thereby sustaining the current "goldilocks" economic phase into the next fiscal year, despite potential global headwinds. The full impact, however, will depend on the swift transmission of these rate cuts by commercial banks to end-borrowers.

India's substantial foreign exchange reserves are a powerful macroeconomic tool that provides a significant buffer.....

 India's large foreign exchange (forex) reserves act as a crucial protective shield against excess currency volatility and depreciation by enabling the Reserve Bank of India (RBI) to intervene directly in the foreign exchange market, thus stabilizing the rupee and bolstering investor confidence. India's forex reserves, which hit a record high of approximately $704.89 billion in September 2024, provide significant resilience against external shocks. The mechanisms through which they achieve this are:

Direct Market Intervention: The RBI maintains a "managed float" exchange rate system. When the Indian Rupee (INR) faces excessive depreciation pressure, the RBI sells foreign currency (primarily US Dollars) from its reserves in the open market. This increases the supply of foreign currency and reduces the supply of INR, thereby counteracting the downward pressure on the rupee's value.

Boosting Market Confidence: A strong reserve position signals to global investors and credit rating agencies that India can meet its external obligations and withstand crises. This confidence helps attract Foreign Direct Investment (FDI) and portfolio inflows, further stabilizing the currency.

Import and Debt Servicing Buffer: The reserves provide a robust import cover (currently sufficient for over 10 months of imports) and ensure the ability to service external debt, even during periods of global uncertainty or supply-chain disruptions. This prevents a balance of payments crisis, a scenario that forced India to pledge gold during the 1991 crisis when reserves were critically low.

Deterring Speculation: Knowing that the RBI has deep pockets to defend the currency deters large-scale, one-directional speculative attacks on the rupee.

Depreciation Around Rate Cut Dates and Speculation

The tendency for the rupee to depreciate around interest rate decision dates in India is often linked to market dynamics and speculative behavior:

Interest Rate Differentials: When the RBI hints at or implements an interest rate cut (or a smaller hike than expected), the return on Indian assets (like bonds) relative to other markets (especially the US) decreases. This encourages foreign portfolio investors (FPIs) to pull their money out of the country to seek higher returns elsewhere, increasing the demand for foreign currency and thus depreciating the rupee.

Self-Fulfilling Prophecy: This expectation of a rate cut leading to capital outflows can create a self-fulfilling cycle. Traders and investors, anticipating others will sell the rupee, increase their own selling pressure (speculation) to profit from the expected depreciation. This collective action can cause the currency to fall, even if the underlying economic fundamentals are strong.

RBI's Counter-Strategy: The RBI uses its forex reserves during these times to manage volatility and prevent excessive depreciation, buying INR and selling foreign currency to maintain orderly market conditions.

India's substantial foreign exchange reserves are a powerful macroeconomic tool that provides a significant buffer against external vulnerabilities and currency speculation. They grant the RBI the capacity and credibility to intervene in the currency markets, ensuring that the INR remains relatively stable despite global headwinds and the predictable speculative pressures that often accompany domestic monetary policy shifts. The current high level of reserves underscores India's economic resilience, a far cry from the vulnerabilities faced in earlier decades.

The RBI's Inflation Projection Is A Form Of Inflation Expectations Based On Expertise.....

 The RBI's projected inflation is considered inflation expectations because it is the central bank's own forecast of future price levels, which influences how the public and financial markets form their own expectations about inflation. These projected figures are a crucial communication tool used to anchor the expectations of businesses and consumers, helping the central bank achieve its price stability goals. By publicly stating its forecast, the RBI signals its policy intentions and helps shape a common understanding of the future inflation outlook. The Reserve Bank of India's (RBI) inflation projection effectively functions as a signal to anchor inflation expectations in the economy, which in turn influences real-world pricing and investment decisions.

The Role of RBI Projections in Anchoring Expectations

Forward-Looking Guidance: Monetary policy operates with significant transmission lags, meaning decisions made today affect the economy several quarters down the line. The RBI's projections communicate its assessment of the future economic landscape and its expected policy actions to manage it, providing a crucial forward-looking view.

Building Credibility: A central bank's primary objective under a flexible inflation targeting framework is to maintain price stability, with a target of 4% CPI inflation within a tolerance band of ±2%. By consistently working to keep inflation within this range and communicating its strategy, the RBI builds credibility. Well-anchored expectations mean that households and businesses adjust their predictions to align with the central bank's target, reducing the impact of short-term fluctuations and fostering a stable economic environment.

Influencing Behavior: When the public and markets trust the RBI's commitment to price stability, their own decisions regarding wage negotiations, price-setting, borrowing, and investment are shaped by the central bank's target and projections. The projection acts as an "anchor" (a psychological reference point), influencing market sentiment and ensuring the central bank's policy signals are effective.

The Case for a Potential Rate Cut

The scenario you described presents a strong argument for a potential rate cut, based on recent data as of late 2025:

Near-Zero Current Inflation: India's CPI inflation hit a record low of 0.25% in October 2025, significantly below the RBI's 2-6% tolerance band and even below its own recent projections. This provides substantial "policy space" to support growth.

High Real Interest Rate: The real interest rate (nominal interest rate minus inflation) becomes high when inflation is near zero, making capital expensive for businesses and potentially stifling investment. With the current repo rate at 5.5% and near-zero inflation, the real rate is high, prompting calls from some economists for a reduction to boost economic activity.

Reinforcing the Trend (Self-Fulfilling Prophecy): A well-signaled rate cut could stimulate investment and consumption, which would support economic growth (which currently sits at a robust 8.2% GDP growth). The resulting boost to investment and supply, as you noted, could reinforce the low-price environment (or bring inflation closer to the 4% target), making the policy outcome a self-fulfilling one.

RBI's Lowered Projections: The RBI has already revised its CPI inflation forecast for FY 2025-26 downwards to 2.6% (from 3.1%). A further lowering of the inflation projection would be a strong signal that the central bank is confident about future price stability, making a rate cut more likely.

In conclusion, the RBI's projections are a vital communication tool that shapes economic behavior. The current context of very low inflation and high GDP growth creates a compelling environment where a strategic rate cut could be implemented to align real interest rates with the low-inflation reality and encourage further investment. The RBI uses complex models to project future inflation based on current economic data, which allows it to anticipate future price changes. By announcing these projections, the RBI communicates its assessment of the inflation landscape to the public. Businesses and consumers adjust their decisions (e.g., pricing, wage demands, purchasing) based on their expectations of future inflation, which are influenced by the central bank's projections. When the public believes the RBI's projections and its commitment to control inflation, it helps "anchor" expectations, meaning they are less likely to deviate significantly from the target. This reduces the likelihood of self-fulfilling prophecies where high inflation expectations lead to actual price increases. The projections help guide the RBI's monetary policy decisions, such as setting interest rates. If the projections indicate inflation will be too high, the RBI may tighten policy; if projections suggest it will be too low, it may consider loosening it.

Low Inflation, Also, Boosted Real Growth By Making Nominal Spending More Effective.....

 India's recent strong real GDP growth in Q1 and Q2 FY2025-26 was a result of a combination of factors: low inflation boosted real growth by making nominal spending more effective, a low base from the previous year provided a statistical boost, and robust government spending, particularly in capital expenditure, helped drive growth across sectors like manufacturing and services. India's real GDP growth accelerated significantly in the first two quarters of FY2025-26, with figures of 7.8% and 8.2% respectively. This impressive performance was not solely due to spending but was significantly amplified by favorable statistical conditions, namely a low base effect from the previous year and a low inflation rate, alongside increased government spending. This analysis attributes the strong growth to these intertwined factors, supported by recent data from Q1 and Q2 FY2025-26.

Low inflation and base effect

Low inflation: Low inflation reduced the gap between nominal and real GDP growth. In Q1 FY2025-26, the gap was only around 1% (8.8% nominal vs. 7.8% real), much smaller than the previous year when high inflation widened this gap. This indicates that the economy achieved strong real gains without a corresponding increase in nominal spending, effectively magnifying the real growth rate.

Low base effect: A lower growth rate in the previous year's corresponding quarter created a more favorable base for the current period. This statistical effect made year-over-year comparisons show a larger percentage increase, as seen in manufacturing which grew at 7.7% in Q1 FY2025-26 compared to the previous year.

Government spending

Capital expenditure: High government spending, especially on capital expenditure (capex), supported strong growth in sectors like manufacturing and construction.

Nominal government final consumption expenditure: Nominal Government Final Consumption Expenditure (GFCE) bounced back, growing at 9.7% in Q1 FY2025-26 compared to 4.0% in the same quarter of the previous year.

Boost for sectors: Government spending helped drive growth in the Secondary Sector (8.1%) and the Tertiary Sector (9.2%), which includes services like public administration, defense, and other services. 

India's strong real GDP performance in the first two quarters of FY2025-26 was a result of a synergistic combination of factors. Low inflation provided a significant boost by allowing real gains to be more apparent, while the low base effect from the previous year amplified the growth figures. This was further bolstered by increased government spending, particularly on capital projects, which stimulated growth in key sectors of the economy. This combination of statistical tailwinds and proactive government investment has created a positive economic environment, evidenced by the robust growth rates observed in recent data.

The Argument That Low Inflation Is beneficial Is Supported By Several Economic Principles And Observed Data.....

 Low and stable inflation in India is indeed a desirable economic condition and a key objective of the Reserve Bank of India's (RBI) monetary policy, contrary to the idea that low inflation is inherently a problem. The RBI has an official target of 4% CPI inflation with a tolerance band of +/- 2%. This approach fosters a stable environment that can lead to enhanced economic outcomes. A moderate, stable, and predictable inflation rate is widely considered beneficial for an economy. It strikes a balance between encouraging current economic activity and preserving the value of money over time. In India, maintaining low inflation is a primary mandate for the RBI, as it underpins macroeconomic stability, fosters investor confidence, and supports sustainable growth. The belief that "low prices mean high demand and supply" reflects the potential stimulus that price stability offers to various economic actors.

Explanation: The Benefits of Low and Stable Inflation

The argument that low inflation is beneficial is supported by several economic principles and observed data:

Boosts Consumer Spending and Investment: Low and stable inflation increases real wages and disposable incomes, allowing consumers to purchase more goods and services. This stability also reduces uncertainty for investors, encouraging long-term investments in productive assets, which is crucial for job creation and income growth.

Enhances Saving: Predictable prices help preserve the real value of after-tax incomes and savings, encouraging individuals and households to save, which in turn provides a stable source of funds for investment in the economy.

Improves International Competitiveness: With the currency depreciating due to external factors, maintaining low domestic inflation boosts the competitiveness of Indian exports in the global market. This can offset the pressure from tariffs and external headwinds, increasing demand for domestically produced goods and services, which is beneficial for the supply side of the economy.

Lowers Borrowing Costs: Low and stable inflation typically leads to lower long-term nominal interest rates. This makes borrowing cheaper for businesses (especially in credit-reliant sectors like infrastructure and MSMEs) and individuals (e.g., for housing), stimulating both demand and supply sides of the economy.

Anchors Expectations and Guides Policy: A key aspect of the RBI's inflation-targeting framework (4% +/- 2%) is to anchor inflation expectations. This transparency helps households and firms make more informed decisions about consumption, saving, and investment, making monetary policy transmission more effective.

Prevents Deflationary Spirals: While high inflation is harmful, deflation (falling prices) is considered an economic problem because consumers delay purchases in anticipation of even lower prices, which can stall economic activity and lead to a recession. A low, positive inflation target prevents this scenario.

Data from an RBI study (April-June 2025) indicated that while private companies' sales grew moderately (5.5%), their net profits surged significantly (17.6%), aided by lower global commodity prices. This suggests that low input costs contributed to robust margins. However, corporate investment (capex) remained weak, indicating that businesses were not investing these profits, potentially due to subdued overall demand or high real interest rates stemming from persistent inflation expectations despite actual low inflation data. A potential rate cut could address this by lowering the perceived cost of capital and encouraging investment, aligning market sentiment with the actual low inflation environment. Low inflation, when resulting from oversupply or increased productivity, is a positive indicator for India's economic health, promoting higher spending, saving, and investment. It helps manage the challenges posed by currency depreciation and global tariff pressures by enhancing competitiveness. While the risk lies in low inflation being a symptom of weak demand, the correct monetary policy response, such as a well-signaled rate cut, can reinforce low and stable inflation and act as a necessary stimulus for both supply and demand. The goal is price stability, which provides a solid foundation for sustainable and inclusive economic growth.

Stagnation of Real Wages, Incomes, and Savings in India.....

India's robust GDP growth in recent years masks a critical underlying issue: the stagnation of real wages, incomes, and household savings for a large segment of the population. This trend, evident in both formal and informal sectors, is primarily driven by high inflation, an excess supply of low-skilled labor, and a shift towards informal and contractual employment, leading to a rise in household debt and the potential for a debt-driven bubble.

Reasons for Stagnant Wages, Incomes, and Declining Savings

Stagnant Real Wages and Incomes

Inflation Outpacing Wage Growth: The primary reason is that rising consumer prices have eroded the purchasing power of nominal wages. Real wages for salaried workers were 1.7% lower in the June 2024 quarter compared to the June 2019 quarter. For casual laborers in rural areas, annual real wage growth has been close to zero or minimal over the last decade.

Excess Labor Supply and Skill Gaps: A large workforce entering the job market, coupled with a lack of quality education and relevant skills, means the supply of labor often outstrips demand for quality jobs. This reduces the bargaining power of workers and keeps wages down, especially at entry and mid-levels.

Informal and Contractual Work: There is an increasing reliance on temporary, gig, and self-employed workers, who generally receive lower pay and fewer benefits than permanent employees. The share of self-employed workers increased from 53.5% in 2019-20 to 58.4% in 2023-24.

Depressed Private Sector Investment: Stagnant private investment in manufacturing and other labor-intensive sectors leads to slower job creation and, consequently, limited wage growth.

Declining Household Savings

High Consumption Needs: With stagnant incomes and rising costs of essentials (rent, education, healthcare), households are allocating a larger portion of their income to daily expenses, leaving less for savings.

Shift to Debt for Consumption: To bridge the gap between income and expenses, households are increasingly resorting to credit. Household liabilities peaked at 6.4% of GDP in FY24, near a 17-year high, reflecting a reliance on borrowing for consumption rather than asset creation.

Low Real Interest Rates: Traditionally popular savings instruments like bank fixed deposits have offered real interest rates that barely beat inflation, making them less attractive and pushing people towards riskier, market-linked investments (equities, mutual funds) or physical assets (gold, real estate).

Changing Investment Patterns: The shift towards less liquid physical assets or volatile financial markets, combined with a "You Only Live Once" (YOLO) mindset and easy digital credit access, further reduces traditional, steady savings pools.

Path to Higher Debt and Potential Bubble

The combination of stagnant real incomes and rising consumption, often funded by easy credit, leads to a significant increase in household debt. The household net financial savings rate fell to a near five-decade low of 5.1% of GDP in FY23, while household debt as a percentage of GDP has climbed. This increased leverage, especially in unsecured loans, raises concerns about financial stability and the risk of a debt-driven consumption bubble, similar to the 2008 US subprime crisis.

Ways to Increase Real Wages, Incomes, and Savings

Addressing this requires a multi-pronged approach focusing on structural reforms:

Skill Development and Quality Education: Investing heavily in quality education and targeted skill development programs can bridge the gap between labor supply and demand for skilled jobs, thereby increasing productivity and wages. The government's existing skill initiatives need to be more effective and cover a wider range of the workforce.

Formalization of the Economy: Encouraging the growth and formalization of small and medium enterprises can provide more stable jobs with better pay and social security benefits, transitioning workers from the vulnerable informal sector.

Boosting Private Investment: Creating a favorable environment for private sector investment, particularly in labor-intensive industries, is essential for generating quality employment and stimulating wage growth.

Strengthening Social Security Nets: Expanding access to affordable health insurance, pension plans, and other social welfare schemes provides a financial safety net, reducing the need for households to borrow during emergencies and encouraging long-term savings.

Promoting Financial Literacy and Inclusion: Educating households about personal finance, risk management, and the benefits of formal savings products can help them make informed financial decisions. This includes the development of user-friendly, tailored savings products for rural and low-income populations.

Macroeconomic Policies:

Inflation Management: Keeping inflation in check is crucial to preserve the purchasing power of incomes and savings.

Tax Incentives: Offering better tax incentives for long-term savings like the Public Provident Fund (PPF) or pension schemes can make them more attractive.

Wage Protection: Implementing and enforcing effective wage protection laws and linking wage adjustments to inflation can ensure sustainable income growth.

India's current economic trajectory, characterized by high GDP growth alongside stagnant real wages and declining household savings, poses a significant risk to long-term stability. The resulting surge in household debt is a coping mechanism for financial strain, not a sign of prosperity. By implementing comprehensive structural reforms focused on human capital development, formal job creation, and robust financial safety nets, India can foster inclusive growth that translates into tangible increases in real incomes and savings for all its citizens, safeguarding the economy from potential debt crises and ensuring a sustainable future.

India risks transforming its potential demographic dividend into a significant socio-economic liability.....

 India's development strategy has faced significant criticism for prioritizing physical infrastructure development over essential investments in human capital, an approach that has arguably championed unskilled employment and contributed to a substantial skill mismatch in its workforce. While this infrastructure focus aims to boost economic growth, comparative data with other developing economies highlights persistent underinvestment in social sectors like education and health, hindering the creation of a highly skilled labor force.

The Investment Imbalance

The Indian government has consistently increased its capital investment outlay for infrastructure, reaching an allocation of ₹11.21 lakh crore (around 3.1% of GDP) for the infrastructure sector in the 2025-26 Union Budget. This massive push in roads, railways, and urban development has created substantial demand for construction and related activities, which primarily absorb low-skilled and unskilled labor.

In stark contrast, government expenditure on human capital development remains low compared to international benchmarks.

Healthcare: India's government health spending was about 1.1% of GDP in 2021 (FY22), significantly lower than the average of 1.7% for middle-income countries and about 3.5% below the average of BRICS nations (excluding India). The total health expenditure (public and private) stands around 3.8% of GDP.

Education: Government education expenditure in India was 4.64% of GDP in 2021. While this is closer to high-income country averages, peer nations like Brazil (5.8% of GDP in 2020) and South Africa (6.6% in 2023) allocate a higher share of their GDP to education.

Vocational Training: Only about 5% of India's labor force has undergone any formal skill training, a figure that pales in comparison to Germany (75%), the UK (68%), and South Korea (96%).

This persistent underinvestment has led to a workforce that is largely unskilled; an estimated 88% of India's young workforce is unskilled.

Consequences: Unskilled Labor and Skill Mismatch

The emphasis on infrastructure-led growth, without a corresponding investment in skills, has created a paradox: a massive potential "demographic dividend" that remains largely "unemployable" in high-productivity sectors due to a lack of relevant skills.

Job-Skill Mismatch: A significant mismatch exists between the skills possessed by the educated youth and the demands of the job market. An Economic Survey revealed that only 8.25% of graduates are employed in roles matching their qualifications, with over 50% working in elementary or semi-skilled jobs that do not require their education levels. This results in underemployment and a "dead-weight loss" of the expenditure on higher education.

Informal Sector Dominance: The organized sector, which often demands higher skills, is highly automated and does not generate enough jobs. The unorganized or informal sector accounts for over 90% of employment, and workers here often engage in low-paying, low-productivity tasks.

Comparative Disadvantage: While countries like China focused on developing a skilled manufacturing workforce to become a global manufacturing superpower, India has struggled with slow employment growth in manufacturing, with a large portion of the labor force remaining in the agricultural sector.

By channeling resources primarily into physical infrastructure rather than human capital, the Indian government's strategy has, by design or default, sustained an economy largely dependent on a vast, unskilled labor pool. Data suggests a critical failure to equip the burgeoning youth population with the necessary skills for a modern, globalized economy. Without a fundamental shift towards substantial and targeted investment in education, healthcare, and formal skill development, India risks transforming its potential demographic dividend into a significant socio-economic liability, falling further behind other developing nations that have successfully prioritized human capital formation.

The Present Level Of Inflation Has A Direct And Significant Bearing On Expectations For The Near Future.....

Inflation expectations are a cornerstone of modern macroeconomics, shaping consumption, investment, and wage-setting decisions for households and firms. In India, understanding how these expectations are formed is particularly crucial for the Reserve Bank of India (RBI) in implementing its flexible inflation targeting (FIT) framework, aimed at maintaining price stability. The theoretical frameworks of adaptive expectations and rational expectations offer contrasting views on the information sources used by economic agents, with empirical evidence in India suggesting a complex, hybrid model where current inflation and prices play a central role, leaning more towards adaptive behavior for households and a more forward-looking approach for professional forecasters.

Adaptive Expectations: The Dominance of Current and Past Prices

The adaptive expectations hypothesis posits that individuals form their expectations about future inflation primarily by looking at past and current inflation rates, adjusting their forecasts based on previous errors. In the context of India, this model is highly relevant, especially for households:

Reliance on Current Perceptions: Indian households' inflation expectations are largely driven by their perceptions of current inflation, which are, in turn, heavily influenced by the prices of frequently purchased items like food and fuel.

Strong Persistence: Studies using the RBI's Inflation Expectations Survey of Households (IESH) data show that a significant portion of the variability in household expectations is explained by their own past perceptions, indicating a strong backward-looking element and inertia in the adjustment process.

Gradual Adjustment: Under adaptive expectations, if actual inflation is higher than expected, individuals will revise their future expectations upwards, but this adjustment is gradual. Current high prices, particularly in volatile segments like food, are often treated as a "permanent structural factor" in the short term, feeding into expectations faster than a broad range of macroeconomic data might suggest, potentially leading to a wage-price spiral if not managed effectively.

Thus, for a large segment of the Indian population, particularly households, current prices matter more than a comprehensive analysis of all available information, confirming a largely adaptive formation process.

Rational Expectations: The Role of Information and Policy Credibility

The rational expectations hypothesis assumes that economic agents are forward-looking and use all available information efficiently, including the central bank's policy announcements and economic fundamentals, to form their expectations. In this framework:

Forward-Looking Behavior: Expectations are based not just on the past, but on projections of future events and policies. Agents are assumed to make predictions that are, on average, accurate and free of systematic bias.

Influence of Policy: The RBI's credibility in maintaining its 4% (±2%) inflation target is crucial here. If the public believes the RBI will achieve its target, expectations will be anchored around that target, making them less sensitive to short-term price shocks.

Professional Forecasters: In India, while household expectations are not considered fully rational, the forecasts by professional forecasters tend to be more aligned with the rational expectations hypothesis, as they incorporate a wider range of data and economic models. They are found to predict actual inflation better than simple backward-looking models.

For rational agents, current prices provide immediate, new information that is rapidly incorporated into expectations about future policy responses and market dynamics. This contrasts with purely backward-looking models that only adjust after a sustained period of error.

In the Indian context, the formation of inflation expectations presents a mixed picture. Current prices and immediate perceptions heavily influence household expectations, aligning with the adaptive expectations model, creating a degree of persistence in inflation dynamics. This means the present level of inflation has a direct and significant bearing on expectations for the near future. Conversely, professional forecasters demonstrate more rational, forward-looking behavior, incorporating all available information and central bank communications. The RBI's effectiveness in anchoring overall inflation expectations relies on a combination of managing current price volatility (especially in food and fuel) and clearly communicating its policy intentions to build credibility and foster more rational, target-oriented expectations across the economy.