Rate hike? Yes, but how long is the cycle?

There was no surprise in the Reserve Bank of India's (RBI's) August monetary policy. The central bank's rate-setting body, the Monetary Policy Committee (MPC), kept the policy repo rate unchanged at 5.25 per cent. The decisions on both the policy rate and the stance (neutral) were unanimous.

 

RBI Governor Sanjay Malhotra's August policy statement offered no forward guidance, as the outlook was "hazy" because of uncertainties over the south-west monsoon, El Niño, geopolitics and global trade policy. But two weeks later, when the minutes of the MPC meeting were released, one couldn't miss the signals of potential rate hikes in the near future, driven by concerns over rising headline inflation and persistent risks from food, fuel and input prices.

 

While Malhotra voted to keep the policy rate unchanged and retain the neutral stance, this is how his statement in the MPC minutes ended: "I would prefer to wait for more certainty to emerge on the inflation trajectory… the forecast and the likely levels to which inflation may normalise and settle, for any recalibration of the policy rate. We also need to be watchful as the risks of higher food, fuel and other input prices translating into a broad-based increase in inflation and de-anchoring of expectations persist. Any evidence of these risks materialising may need policy tightening."

Is the time right for policy tightening?

First, a look at what global central banks have done since the last RBI policy.

 

Since August, global monetary policy has taken a broadly hawkish turn. Persistent inflation pressures, rising sovereign bond yields and high fuel costs have led several major central banks to resume rate hikes. Of course, some central banks have chosen to ease policy to support domestic growth.

 

The US Federal Reserve, the European Central Bank and the Bank of Japan have raised policy rates, while the Bank of England has held its rate at 3.75 per cent in a split 6–3 vote. Though underlying inflation remained sticky, slack in the domestic economy held the UK central bank back from an immediate hike.

 

The Fed's 25-basis point (bps) hike, which took the federal funds rate to a target range of 3.75-4 per cent, is its first since July 2023. One basis point is one-hundredth of a percentage point. US inflation has remained above the 2-per cent target for more than five years, raising concerns that inflation expectations are becoming entrenched.

 

The Bank of Japan's 25-bps hike to 1.25 per cent, the highest level since 1995, signals its determination to continue normalising monetary policy amid steady domestic wage growth and persistent upside risks to inflation.

 

Brazil's central bank, meanwhile, cut its policy rate by 25 bps to 13.75 per cent in mid-September, its fifth cut in a row, amid firmer signs of an economic slowdown. Yet despite 125 bps of cuts since March, Brazil still has one of the highest real interest rates among major economies.

 

On Thursday, the last trading day before this week's policy meeting, the rupee closed at 96.31 to the dollar, its weakest level in two months. This is despite more than $143.5 billion of inflows through the RBI's concessional dollar-rupee swap window, operational since June 8. The 10-year government bond yield rose to 7.21 per cent, its highest since April 2024. Incidentally, on that day, the US 10-year Treasury yield rose to 5.34 per cent, its highest since 2002.

 

What about the equity market? Both the Nifty and the Sensex fell more than three-quarters of a per cent that day. With this, the benchmark indices have ended in the red for eight straight weeks, their longest losing streak in 25 years. In the first nine months of 2026, foreign portfolio investors (FPIs) have pulled out at least Rs3 trillion from Indian equities, surpassing all annual outflow records.

 

Globally, high commodity prices and continued geopolitical uncertainty have made the central banks of developed markets hawkish. The gap between US and Indian bond yields has been shrinking. Going by Thursday's rates, the difference in 10-year yields is less than 200 bps. Foreign investors no longer have much of an interest rate buffer.

 

Despite the tax exemption on interest income and capital gains for FPIs in government bonds, they have shown little appetite. In fact, the RBI's staunch defence of the rupee may encourage them to exit before the rupee depreciates further to escape the currency risk. The US dollar is currently rallying against almost all major emerging market currencies, driven by surging US Treasury yields and expectations of another Fed rate hike.

 

This is one side of the story. On the other side, high oil prices (which are pushing up freight costs) and other elevated input costs are feeding into retail inflation. Add to that rising food prices because of a deficient monsoon. India's 2026 south-west monsoon ended with a 12.6-per cent rainfall deficit, the driest season in 11 years, even as the threat from the ongoing El Niño remains severe.

 

Retail inflation could breach the upper end of the RBI's tolerance band (6 per cent) in the current quarter. In August, the RBI left its retail inflation projection for the third quarter unchanged at 5.9 per cent and raised the fourth-quarter estimate by 10 bps to 5.5 per cent. I will not be surprised if it raises the inflation estimates again for the third quarter.

 

Real gross domestic product (GDP) grew 7.8 per cent in the first quarter of FY27, beating consensus estimates as well as the projections of the RBI and global agencies. Corporate margins expanded in the first quarter, and the trend possibly continued through the first half of the fiscal year. Bank credit growth, too, was a handsome 18.1 per cent as of mid-September, pointing to a narrowing output gap.

 

All this has prompted several global agencies to raise their India growth forecasts. Recently, S&P Global Ratings and the Asian Development Bank raised theirs from 6.6 per cent to 7 per cent; Fitch Ratings from 6.4 per cent to 6.9 per cent; and the Organisation for Economic Co-operation and Development (OECD) from 6.3 per cent to 7.1 per cent. Earlier, the World Bank upgraded its forecast from 6.5 per cent to 6.6 per cent in June, while the International Monetary Fund trimmed its forecast from 6.5 per cent to 6.4 per cent in July.

 

In August, the RBI raised its first-quarter GDP growth projection by 40 bps to 7 per cent and its second-quarter projection by 10 bps to 6.4 per cent, but left the estimates for the third and fourth quarters unchanged at 6.5 per cent and 6.8 per cent, respectively. It is expected to raise its growth projection again, at least for the second quarter.

 

Given the current growth-inflation dynamics, a hike in the policy rate is likely. The last time the RBI raised the repo rate was in February 2023, to 6.5 per cent. After holding it at that level through 2023 and 2024, the RBI cut the rate by a cumulative 125 bps between February and December 2025.

 

How many rate hikes should we expect in this cycle? The overnight indexed swap (OIS) market is pricing in four 25 bps hikes. Here traders exchange a fixed interest rate for a floating rate tied to an overnight benchmark -- a gauge of future monetary policy expectations.

 

While a rate hike this week is all but certain, it's difficult to guess the length of the cycle at this point. There could be at least one more hike in December. Rising rates will affect both private capex and the government's cost of borrowing. For the economy, it's a double whammy: High input prices and high credit costs. We need to watch how entrenched inflation is and how demand-led growth is. How sustainable is the 10.3 per cent nominal GDP growth of the first quarter? Why isn't the asset market performing?

 

This is why the stance may remain unchanged. The RBI will also focus on managing the liquidity deluge in the system, a result of the forex inflows. More than the action, the market will closely watch the central bank's communication.  ____________________________________________________________________________________________________ 

 

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