Confronting Economic Trade-offs: RBI and Impossible Trinity

The Lift Line

“For credibility, the MPC and RBI must demonstrate the same willingness to tighten monetary conditions as they showed in easing them.” (Ananth Narayan, Business Standard)

Why This Editorial Matters for Your Exam

In the news: In his “Policy in Practice” column in Business Standard of 20 October 2026, “Confronting economic trade-offs”, Ananth Narayan, a former whole-time member of the Securities and Exchange Board of India (SEBI), reads the RBI’s easing of 2025-26 as an attempt to have low rates, a stable rupee and capital inflows at once. The impossible trinity, he argues, rules that out. His remedies: market-determined interest rates, a lower tax on fixed income and residence-based taxation of foreign portfolio investors.

Read it with our notes on the MPC’s 25 bps hike to 5.50 per cent on 7 October and the RBI’s 10 October foreign exchange measures. Three more columns of the day take up the same theme: Rajeswari Sengupta on the RBI’s rupee fix and the FCNR(B) swap, C. Rangarajan and N.R. Bhanumurthy on inflation and the supply of money, and Ajit Ranade on how India’s high interest burden muddles the RBI’s task.

GS Paper 3: Indian economy and issues relating to mobilisation of resources; monetary policy and the RBI; the external sector and capital flows; taxation of savings and capital markets. Essay: choices and trade-offs in economic policy.

UPSC Relevance. Prelims: the impossible trinity; the repo rate path of 2025-26; open market operations; the inflation target under Section 45ZA of the RBI Act, 1934 and the six-member MPC; the 2014 Urjit Patel Committee; ordinances under Article 123 and the Act that replaces one; the 2026 tax exemption for FIIs and the BIS. Mains: interest-rate repression and its side effects, capital flows and the rupee, tax design and household savings, and the credibility of monetary policy.

Background and Context

The rate cycle, 2025 to 2026

The four cuts of 2025 add up to 125 bps. In its Governor’s Statement of 7 October 2026 the RBI said that “rate cuts are off the table in the near term and policy action ahead can only be a rate hike or a pause”. So the 5.25 per cent in Narayan’s account is the end-2025 level; the repo has been 5.50 per cent since 7 October 2026.

Inflation in 2025. Narayan writes that consumer inflation averaged “just 2 per cent” in 2025. On the old CPI series (base 2012=100), headline inflation eased from 4.26 per cent in January 2025 to 1.33 per cent (provisional) in December 2025. For context, a new CPI series (base 2024) began with the release of 12 February 2026.

The impossible trinity and the Patel Committee

The impossible trinity (or trilemma) says a country cannot at the same time have free capital mobility, an independent monetary policy and a fixed exchange rate; it must give up one. Narayan lists the three as “Monetary independence, capital mobility and exchange-rate stability”.

The RBI’s expert committee chaired by Urjit Patel (report released 21 January 2014) wrote: “The conduct of monetary policy in a globalised environment faces the challenge of managing the impossible trinity.” It added that the trilemma “has collapsed into a dilemma”, with independent monetary policy possible only if the capital account is managed. On priorities it said: “bringing down inflation must be accorded primacy. Anchored inflation expectations will then provide the latitude to address other objectives without compromising on price stability.” It recommended an inflation target of 4 per cent with a band of plus or minus 2 percentage points. Flexible inflation targeting got a statutory basis through the Finance Act, 2016 (in force from 27 June 2016): under Section 45ZA(1) of the RBI Act, 1934, “The Central Government shall, in consultation with the Bank, determine the inflation target in terms of the Consumer Price Index, once in every five years.” The Monetary Policy Committee of six (Section 45ZB) sets the policy rate to achieve it. For background, the RBI released a Discussion Paper on Review of Monetary Policy Framework on 21 August 2025.

Selling bonds in 2026-27

As context for the column, between 17 September and 13 October 2026 the RBI held four open market operation (OMO) sale auctions of government securities, all fully accepted:

• 17 September: Rs 50,000 crore
• 21 September, 28 September and 13 October: Rs 25,000 crore each

That makes Rs 1,25,000 crore (Rs 1.25 trillion) in gross sales. The RBI tied them to “current and evolving liquidity conditions”; Narayan reads them as absorbing the liquidity created by its FX swap scheme.

The 2026 tax exemption: ordinance, then Act

As background, the Income-tax (Amendment) Ordinance, 2026 (No. 2 of 2026), promulgated on 5 June 2026 and “deemed to have come into force on the 1st day of April, 2026”, inserted two entries in Schedule IV of the Income-tax Act, 2025:

• Sl. 13D: “Any interest on Government security, and any capital gains arising from the sale, exchange or transfer of such Government security”, for a Foreign Institutional Investor, subject to furnishing information as prescribed.
• Sl. 13E: the same relief for the Bank for International Settlements (BIS).

For context, before the ordinance, according to the Government’s explainer (PIB, 6 June 2026), FIIs were taxed on such income under Section 210 of the Income-tax Act, 2025: 20 per cent on interest, 30 per cent on short-term and 12.5 per cent on long-term capital gains. The ordinance, made under Article 123, has since been replaced by the Taxation and Other Laws (Amendment) Act, 2026 (No. 21 of 2026), enacted in August 2026 (assent 17 August 2026). The Act repeals the ordinance and keeps Sl. 13D and 13E, so the exemption still covers income arising since 1 April 2026. The relief covers government securities only, and it applies to FIIs and the BIS, not to all foreign investment.

The Issue, Decoded

The Analysis

1. What happened. With inflation low, the MPC cut the repo rate by 125 bps to 5.25 per cent in 2025. Narayan adds that in 2025-26 the RBI also bought government bonds worth 2.5 per cent of GDP, by his figures 70 per cent more than in 2020-21 and 85 per cent of the Centre’s net borrowing, to support growth and to replace liquidity drained by foreign exchange outflows.

2. The wrong price-setter. Bond yields fell, and by his account the India-US 10-year yield gap fell below 2 percentage points, a multi-decade low. That might look reasonable, since the inflation gap had also narrowed. His objection is about who set the price: “In India, the lender pushing down interest rates was the RBI, not willing savers.” For discretionary savers, post-tax returns on fixed-income “remained unattractive”.

3. The side effects. Repressing rates “so forcefully has consequences”, he writes:

• savings moved from fixed income to equities, adding to “pockets of overvaluation”;
• net foreign inflows struggled, partly because of high equity valuations, and outward direct investment rose;
• narrower rate differentials compressed dollar-rupee forward premia, making hedging and speculation against the rupee cheaper.

4. The leaky bucket. By the author’s count the RBI net sold $192 billion in currency markets across 2024-25 and 2025-26, much of it to meet hedging and speculative dollar demand. The sales drained rupee liquidity and markets signalled the need for higher rates; instead, he argues, the RBI’s bond purchases “poured durable liquidity into a leaky bucket”. Short-term instruments could have refilled liquidity without depressing long-term yields. The rupee kept weakening, and fell further after the Iran conflict, he writes. “We sought low rates, currency stability, and capital inflows”, yet despite large interventions, subsidised FX swaps and restrictions on currency trading, “pressures persist”.

5. Three lessons.

• The trinity matters. The 2014 Patel Committee recognised it; Narayan says the RBI’s August 2025 framework review “did not even mention this trilemma”.
• Communication. Pursuing several conflicting objectives while avoiding trade-offs “risks undermining credibility”.
• Consistency. Large interventions in linked markets have unintended effects, so the debate should move from “let the rupee find its own level” to “let both the rupee and rupee interest rates find their own levels”.

6. The way forward, in his words and proposals.

• Market-determined rates. Let discretionary savings largely fund borrowing; free debt markets allow freer and more stable currency markets. He credits the 2026-27 bond sales and this month’s rate hike, but notes an India-US spread of 230 bps against a historical median of around 400 bps, by his figures, and doubts that this will draw savings into Indian debt. Moving banking liquidity towards neutral would let markets set bond yields.
• Tax on fixed income. Tax interest income, including on fixed deposits, at “the lower of, say, 20 per cent or the applicable slab rate”, and tax capital gains on debt funds on a par with equities. Revenue losses may be limited, he argues, since tax-sensitive savers likely avoid direct fixed income already.
• Residence-based taxation of FPIs. India is “an outlier” in taxing foreign investors’ capital gains on non-controlling portfolio investment in equities and corporate bonds. The June 2026 relief for government securities is “a useful precedent”; extend it to corporate bonds and equities, and offset the revenue with a higher STT for foreign investors, particularly on high-turnover derivatives.
• Consultation. Capital-market tax reforms deserve consultation “akin to the ones that regulators undertake”.

Data and Institutions Vault

Prelims-grade facts:

Monetary policy:

• 2025: four repo cuts, 125 bps in all, to 5.25% (5 December 2025).
• 7 October 2026: repo raised 25 bps to 5.50%; stance changed to calibrated tightening.
• Inflation target: set by the Centre in consultation with the RBI, once every five years (RBI Act, Section 45ZA).
• MPC: six members (Section 45ZB); it sets the policy rate to achieve the target.
• Urjit Patel Committee: report released 21 January 2014; inflation given primacy; target 4% with a band of plus or minus 2 points.

Bonds and liquidity:

• 2026-27 OMO sales: four auctions, 17 September to 13 October 2026, Rs 1,25,000 crore gross.

Tax on government securities:

• Income-tax (Amendment) Ordinance, 2026: promulgated 5 June 2026, in force from 1 April 2026; repealed and replaced by the Taxation and Other Laws (Amendment) Act, 2026 (assent 17 August 2026).
• Schedule IV, Income-tax Act, 2025: Sl. 13D (FIIs) and Sl. 13E (BIS) exempt interest and capital gains on government securities.
• Earlier FII rates (PIB): 20% on interest, 30% short-term and 12.5% long-term capital gains.

Watch the trap: 5.25% was the repo at the end of 2025; it is 5.50% since 7 October 2026. The 2026 relief began as an ordinance (5 June) and is now in an Act (17 August 2026); it covers FIIs and the BIS on government securities only.

The Debate

The author’s case. India tried to hold low rates, a stable rupee and capital inflows together and paid in savings shifted to equities, weak inflows and cheap speculation against the rupee. Let markets set both the exchange rate and interest rates, tighten as willingly as it eased, and use tax reform to make fixed income and Indian debt attractive.

The other side.

• Easing had a basis. Inflation was low through 2025, falling to 1.33 per cent (provisional) in December, and Narayan himself concedes that the narrower inflation gap made lower yields look reasonable.
• Growth. Higher rates can hurt growth, as he acknowledges; his answer is that lower tax on fixed income can allow lower headline rates.
• Revenue. Taxing interest at a lower rate and exempting foreign portfolio gains costs revenue. He expects the loss to be limited and offset by a higher STT, but that is an estimate, not a costing.
• Managing the capital account. The Patel Committee itself said the trilemma “has collapsed into a dilemma”, with independent monetary policy possible only if the capital account is managed. On that view, some management of flows is part of the framework, not a failure of it.
• Fairness. Residence-based taxation can look like a concession only for foreigners; Narayan answers that their gains stay taxable at home and that Indian residents investing abroad largely pay capital gains tax only in India.

The balanced verdict. The trinity is not a slogan: rates, the rupee and capital flows move together, and holding one down shifts the pressure to another. The October 2026 hike and the bond sales show the RBI already moving towards tighter conditions. Narayan’s tax proposals are worth testing in open consultation with revenue estimates, so that tax design, not repressed rates, carries part of the burden of drawing savings and foreign capital.

How to Think About This

For any question on the rupee or interest rates, draw the triangle first: capital mobility, monetary independence, exchange-rate stability. Then ask which corner the policy is giving up and who bears the cost. Second, ask who sets the price: if the central bank, not willing savers, is pushing yields down, expect side effects elsewhere (savings, flows, the currency). Third, look for the non-monetary lever: taxes on interest, capital gains and transactions change the return a saver sees, so tax design can do part of the work that rates are otherwise forced to do. An answer that names the trade-off, the price-setter and the tax lever reads as analysis, not opinion.

Diagram-in-Words

Takeaway Box

• Core idea: low rates, a stable rupee and capital inflows cannot all be had at once; let both the rupee and interest rates find their levels and use tax reform to draw savings.
• Key fact: repo cut 125 bps to 5.25% in 2025, raised 25 bps to 5.50% on 7 October 2026; the 2026 exemption for FIIs and the BIS on government securities (ordinance of 5 June, replaced by an Act on 17 August).
• Counterpoint: low inflation justified easing, tax changes cost revenue, and the Patel Committee itself saw managing the capital account as part of the framework.
• Mains use: impossible trinity, interest-rate repression, credibility and symmetric policy, tax design for household savings, residence-based taxation of FPIs.

Revision Flowchart

Sources:

• Ananth Narayan, “Confronting economic trade-offs”, Business Standard, 20 October 2026 (online 19 October)
• RBI: MPC decisions of 9 April 2025, 6 June 2025 and 5 December 2025; Governor’s Statement, 7 October 2026
• RBI press releases on OMO sale auctions (11 September and 9 October 2026, and auction results)
• Report of the Urjit Patel Committee on the monetary policy framework (RBI, January 2014); RBI Discussion Paper on Review of Monetary Policy Framework (21 August 2025); Reserve Bank of India Act, 1934
• Income-tax (Amendment) Ordinance, 2026 (Gazette of India, 5 June 2026); PIB explainer, 6 June 2026; Taxation and Other Laws (Amendment) Act, 2026 (Gazette of India, 17 August 2026)
• MoSPI, CPI release for December 2025 (12 January 2026)

Source: Confronting Economic Trade-offs: RBI and Impossible Trinity — Ujiyari.com | Free UPSC & State PCS Editorial Analysis