RBI MPC meet: Amid inflation, growth concerns, rate hike can wait for now

Inflation will rise in the second half of the year. Growth, too, will falter. It's time to explore other options

The Indian central bank’s rate-setting body, the Monetary Policy Committee (MPC), will hold its second meeting of FY27 this week. 

What can we expect? 

Globally, quite a few central banks have raised the key policy rates in the past two months, since the MPC’s last meeting on April 5-8. At that time, the West Asia crisis was just five-week old. It remains the backdrop of the current policy too and may not end soon. 

The list of central banks that have either raised the rate or cash reserve ratio since the Reserve Bank of India’s (RBI’s) last policy include those of Sri Lanka, Australia, Norway and Indonesia, among others. The quantum of rise varies between 25 basis points (bps) and 100 bps. The main triggers for such hikes are surging inflation and currency depreciation. One bps is a hundredth of a percentage point. 

Will the RBI follow this group or remain in the same league as the US Federal Reserve, European Central, Bank of England and Bank of Canada? There is intense debate on a rate hike by this quartet that had last raised their policy rates between July and September 2023. 

In India, let’s take a look at what has changed since the April policy. 

At the last policy, the repo rate was kept unchanged at 5.25 per cent, the standing deposit facility (SDF) rate at 5 per cent and marginal standing facility (MSF) rate at 5.5 per cent. The SDF is a window where banks can park their excess cash with the RBI overnight to earn interest; the MSF window offers short-term money to banks, if they need. The repo rate is in the middle of the liquidity management corridor and the overnight call rate can vary between the SDF and MSF, depending on liquidity in the system. 

Around the time of the April policy, the 364-day treasury bill yield was 5.63 per cent, the three-month bill 5.3 per cent and the 182-day bill yield was 5.53 per cent. The one-year certificate of deposits (CDs) rate varied between 7.1 and 7.4 per cent and the one-year commercial papers (CPs) between 7.4 and 7.6 per cent, depending on the credit rating of the borrowers. Corporations raise short-term money through CPs, and banks through CDs. 

Since then, the 364-day treasury bill yield has risen to 6.02 per cent, the three-month bill 5.56 per cent and the 182-day bill to 5.735  per cent. The one-year CD rate now varies between 7.75 and 8.25 per cent and the one-year CP between 7.6 and 8 per cent. 

The widening gap between the one-year T bill yield and the one-year CP/CD tells the story of a disconnected policy rate because of funding pressure in the system — for both banks and corporations. 

Is it time to hike the repo rate? 

Let’s look at some other critical indicators. The 10-year bond yield oscillated between 6.90 per cent and 7.14 per cent. During this time, the gap between the US 10-year treasury paper and Indian 10-year paper has shrunk from 2.61 percentage points to 2.52 percentage points. The compression is a disincentive for foreign money flow in this space. 

How has the local currency behaved during this time? On 8 April, the day of the last policy, every dollar fetched ₹92.58. On Friday, it closed at 95 a dollar after hitting a high of 94.96. (A few weeks ago, it hit an intra-day low of 96.91 before closing at 96.82 a dollar.) On April 10, India’s foreign exchange reserves were a little over $700 billion; on May 22, it was around $681 billion. 

The drop in the forex pile is driven by the RBI’s dollar sale and fluctuations in the exchange rate between the dollar and other foreign currencies in the basket. For every dollar the RBI buys to iron out volatility in the foreign exchange market, it sucks out rupee liquidity from the system, and, to balance liquidity, it conducts buy-sell swaps. This also keeps the forex reserve level high. After netting off forex forward sales, the reserves seem to be around $580 billion. 

Meanwhile, the liquidity in the system, which was around ₹4.3 trillion in April has come down to just ₹55,000 crore now. 

The “disconnect” in the policy rate architecture is more pronounced at the cut-off yield at government bond auctions. The central government is borrowing four-year money at 6.7 per cent, 7-year at 7.06, and 30-year at 7.67 per cent. 

The state governments are paying even more — 7.78 per cent for nine-year bonds, 7.84 per cent for 15-year, and 7.87 per cent for 18-year. One can borrow at 5.5 per cent from the MSF window of the RBI, offering such papers as collateral. Clearly, the market is demanding a high premium from the government. 

There is no correlation between the repo rate and government papers beyond six-month maturity. The challenge for the RBI is to anchor the repo rate at this juncture. 

Before pressing pause in February this year and continuing with it in April, between February and December 2025, there was a 125-bps rate cut — the most aggressive easing since 2019. 

At the April policy, the MPC left the policy rate unchanged at 5.25 per cent by a unanimous decision and it also decided to continue with a “neutral” stance. 

Assuming the adverse impact of the West Asia conflict would not last long, the April policy projected real gross domestic product (GDP) growth for FY27 at 6.9 per cent with downside risks if the war continues. It projected the consumer price index (CPI)-based inflation for FY27 at 4.6 per cent. It’s for sure that the RBI will revise the GDP estimate downwards and inflation estimate upwards. 

Will the RBI go for a rate hike to fight the second-round impact of cost-push inflation, driven by supply shocks (and the decade’s driest monsoon looming), something which governor Sanjay Malhotra has been warning against? My guess is that it will refrain from doing so. It will continue to monitor all data and will wait before taking the rate action. Since the current stance is neutral, it has the flexibility. 

There are four major concerns at this point: A falling rupee; capital outflows (current account deficit too is widening) and supply shocks leading to higher inflation; and weakening growth. Instead of using a rate hike to defend the rupee and attract foreign capital, the RBI probably needs to explore other options. 

A central bank’s intervention in the forex market is akin to blood transfusion to a patient while the real cure lies elsewhere. The suppression of interest rate through aggressive open market operations and liquidity infusion through buy-sell swaps makes debt rates unattractive for domestic investors who flock to the equity market. Foreign investors have been fleeing for other reasons. It’s time to explore options beyond selling dollars and raising rates. 

One of them could be raising NRI deposits. The RBI raised $26 billion through this route in 2013 offering a subsidised swap window where banks could deposit the foreign currency raised and get the rupee equivalent while fully hedging the exchange rate risk at a cheap, fixed rate. It can work out a similar formula for corporations to raise foreign capital through banks. Indeed, capital has a cost but it’s worth experimenting now as there seems to be no attraction for a free flow at this point. 

Inflation will rise in the second half of the year. Growth too will falter. For now, the rate hike can wait. 

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