A new policy cycle

More repo rate increases are imminent

The Reserve Bank of India (RBI) has joined other major central banks, such as the United States Federal Reserve, in increasing policy interest rates to contain inflationary pressures. The six-member Monetary Policy Committee (MPC) of the RBI on Wednesday increased the policy repo rate by 25 basis points to 5.5 per cent, as the financial market widely expected. The policy stance was also changed from “neutral” to “calibrated tightening”. Given the inflation projections, RBI Governor Sanjay Malhotra rightly underscored in his statement that rate cuts were off the table in the near term, and that policy action in the coming months would either be a rate increase or a pause. This gives the financial markets and other stakeholders considerable clarity on the near-term policy path.

 

The MPC increased its inflation projection for this financial year to 5.2 per cent from 5 per cent. It was also underscored that the inflation rate in the next three quarters, including the current quarter, would average about 5.8 per cent. Assuming the projections hold, with the repo rate at 5.5 per cent, the real policy rate in these quarters, on average, will be negative. Thus, more policy tightening is imminent, which explains the shift in stance. Given the inflation projections, it is safe to assume that the repo rate will be increased again in the MPC’s December meeting. Beyond that, the policy action will depend on actual inflation outcomes and possible shifts in future projections. A lot will also depend on the situation in West Asia and its impact on crude-oil prices. The biannual Monetary Policy Report, also released on Wednesday, shows that the RBI expects an average inflation rate of 5 per cent in 2027-28. Monetary policy in 2027 will also depend on the level of the real policy rate that the RBI considers appropriate for the Indian economy. A July 2024 study by the RBI staff had estimated the natural rate — the real policy rate that is neither expansionary nor contractionary — at 1.4-1.9 per cent. According to this estimate, there is scope for a rate increase of about another 100 basis points. It is possible that the estimate for the natural rate would have changed since then. Even though it is more of a theoretical concept, the RBI would do well to periodically assess it to inform monetary-policy formulation and debate.

 

The MPC also increased its gross domestic product (GDP) growth projection for this financial year by 40 basis points to 7.1 per cent. GDP growth for next financial year is projected at 7 per cent. Given the strong growth outlook, the MPC can focus on containing inflation. Overall, despite economic uncertainties, the near-term path for the MPC is relatively clear. Nevertheless, liquidity and currency management will keep the RBI occupied in the near term. Liquidity in the banking system is abundant, which could affect monetary-policy transmission. The weighted average call rate, the operational target of monetary policy, has been running in the lower half of the policy corridor. On the currency front, the rupee continues to be under pressure despite significant intervention by the RBI. It would be worth watching to what extent the RBI will be willing to use the recent surge in foreign-exchange reserves accumulated through the concessional swap schemes. In fact, rupee depreciation can help address the imbalance on the external front. Aside from monetary policy, the RBI also announced a consumer-centric measure that is worth highlighting here. It is facilitating depositories to include deposit-related information in the consolidated account statements of investors. This will help investors keep track of their financial investment.