Hawkish hike, but measured path ahead

Depending on growth-inflation dynamics, the repo rate could rise to 6-6.25 per cent next year

As expected, the Monetary Policy Committee (MPC), the rate-setting body of the Reserve Bank of India (RBI), has raised the policy repo rate by a quarter of a percentage point to 5.5 per cent. It has also changed its stance to “calibrated tightening”.

 

The six-member MPC voted unanimously for the hike, while the change in stance was carried by a 4-2 vote.

 

The RBI rarely describes its stance as “calibrated tightening”. The usual descriptors are “accommodative” and “neutral”; during the 2022-23 tightening cycle, it used “withdrawal of accommodation”.

 

The MPC first adopted a “calibrated tightening” stance in October 2018, under then-RBI governor Urjit Patel, moving from “neutral” while keeping the repo rate unchanged at 6.5 per cent amid rising international crude oil prices and foreign exchange volatility. The December 2018 policy retained the stance, again with no rate action.

 

In February 2019, as inflationary pressures abated, the stance was changed back to “neutral” and the policy rate was cut by a quarter of a percentage point to 6.25 per cent. By then, Shaktikanta Das was at the helm of the central bank.

 

Governor Sanjay Malhotra’s statement that “rate cuts are off the table in the near term and policy action ahead can only be a rate hike or a pause, depending on the evolving conditions and the outlook” has triggered an intense debate on the length of the current rate hike cycle. Most analysts are pencilling in a further three-quarters to one percentage point of hikes, which would take the policy rate to 6-6.25 per cent.

 

A December rate hike looks all but certain, after which the MPC is likely to proceed in a measured way. That is why the stance is “calibrated tightening”. The governor’s statement says: “The duration and extent of the rate hike cycle would be contingent on the actual growth-inflation developments and outlook, especially that of underlying inflation, the extent of broadening of price pressures and second round effects of the supply shock, as also the impact of demand impulses.”

 

The RBI last raised the repo rate in February 2023, to 6.5 per cent. After holding it there through 2023 and 2024, it cut the rate by a cumulative 125 basis points (bps) between February and December 2025. One basis point is one-hundredth of a percentage point.

 

On Wednesday, the broader equity market slipped, but the Bank Nifty rose initially, as banks are expected to raise lending rates, which will boost their net interest margins. Nifty and Sensex closed 0.75 per cent and 0.58 per cent lower, respectively; Bank Nifty closed marginally lower. With the financial system flush with liquidity, deposit rate hikes will have to wait. Transmission of the rate hike cycle for depositors will not be overnight, while the loan cost will rise fast for the borrowers.

 

The 10-year government bond yield rose to a three-year high at 7.24 per cent and, despite the rate hike, the rupee slipped to 96.77 against the dollar.

 

The RBI has raised both its growth and inflation projections for the current financial year and given its estimates for the first quarter of the next year.

 

Citing continued supply-side pressures from a deficient southwest monsoon, El Niño conditions and high volatility in international oil prices, the RBI said: “inflation and its outlook are not benign”. It has projected consumer price index inflation for FY27 at 5.2 per cent and core inflation at 4.4 per cent. Inflation is expected to peak at 6 per cent in the third quarter, and the estimate for the first quarter of FY28 is 5.6 per cent.

 

These estimates give a sense of how far the current cycle could run. With inflation projected at 6 per cent in the third quarter and 5.6 per cent in the first quarter of next year, the policy rate needs to rise to 6-6.25 per cent to keep the real interest rate positive.

 

Incidentally, the monetary policy statement does not give an estimate of the crude oil price. In the June and August reviews, the RBI maintained a baseline assumption of $85 per barrel for its 2026-27 projections. But the Monetary Policy Report, released alongside the policy on Wednesday, has revised the assumption to $95 per barrel for the second half of the year.

 

The price of the Indian crude basket rose from $82 a barrel in July to around $114-116 a barrel in September.

 

The RBI has raised its real gross domestic product (GDP) growth projection for FY27 by 40 bps to 7.1 per cent. After a strong showing in the first two quarters, growth is expected to slow in the second half. Real GDP growth for the first quarter of FY28 is also projected at 7.1 per cent.

 

This is in line with the estimates of most global agencies. The World Bank and the Organisation for Economic Co-operation and Development have both raised their India growth forecasts for the current financial year to 7.1 per cent. S&P Global Ratings, the Asian Development Bank and Moody’s project 7 per cent, while Fitch Ratings has pegged it at 6.9 per cent.

 

For both inflation and GDP growth, the “risks are evenly balanced”.

 

Following $143.6 billion of foreign exchange inflows through the special swap facility opened in June, the banking system has seen a daily average liquidity surplus of ₹5.9 trillion since the last MPC meeting in August, though this has moderated recently.

 

Malhotra did not outline a specific tool to absorb liquidity, but said: “The Reserve Bank will use an appropriate mix of liquidity management tools and strive to align the weighted average call rate with the policy repo rate.”

 

To absorb excess cash from the banking system, the RBI has been selling government bonds through open market operations and holding variable rate reverse repo auctions. Malhotra said it would continue to do so, and that raising banks’ cash reserve ratio (CRR), the portion of deposits banks must keep with the RBI without earning interest, would be the last resort. Fresh FCNR(B) deposits mobilised under the special scheme have been exempted from both CRR and the statutory liquidity ratio.

 

In his post-policy media interaction, Malhotra also referred to the central bank’s dollar sales to keep the rupee stable, which also helps drain liquidity from the system. Asked about the value of the rupee against the dollar, he said: “By a number of estimates, including the REER, the rupee is not overvalued; it may be undervalued.”

 

REER stands for real effective exchange rate. It’s the weighted average of a currency’s value against a basket of trading partners’ currencies, adjusted for inflation differences between them, and is a measure of trade competitiveness. The RBI’s six-currency REER basket covers roughly 40 per cent of India’s foreign trade, while the broader 40-currency index covers about 88 per cent of its merchandise trade.

 

 The writer is an author and senior advisor to Jana Small Finance Bank Ltd. His latest book: Roller Coaster: An Affair with Banking. To read his previous columns, log on to www.bankerstrust.in.

X: @TamalBandyo