Policy prospects: Inflation projections demand monetary tightening

The RBI's decision to hold rates reflects easing inflation risks for now, but rising price pressures could warrant policy tightening in the coming months

As widely expected by financial markets, the three-day meeting of the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) left the policy repo rate unchanged on Wednesday. It had valid reasons not to act at this point. Although the inflation rate in June came at 4.4 per cent and was above the target of 4 per cent, it is worth remembering that the rate was below target for 16 consecutive months. Thus, some normalisation is to be expected. Further, the inflation rate is largely driven by prices of fuel and food. The core inflation rate — excluding food and fuel — was at 3.9 per cent in May and June. The rate was much lower once precious metals were also removed. Thus, it can be argued that inflation is not yet generalised. A possible truce in West Asia can relieve the pressure from energy prices. Besides, it made sense at this stage to wait and see how the monsoon pans out. 

However, things may not remain as straightforward in the coming months. Although the inflation projection for this financial year has been lowered by 10 basis points to 5 per cent, the rate is expected to increase in the coming quarters. The inflation projection for the first quarter of 2027-28 is at 5.3 per cent. Thus, assuming the RBI’s projections hold, the inflation rate will be well above 5 per cent for three quarters starting the third quarter of 2026-27. Even though the rate would still be under the upper end of the tolerance band, it will be significantly above the medium-term target of 4 per cent. Further, the policy repo rate at the current level of 5.25 per cent could turn negative in real terms. Since the monetary policy needs to be forward-looking, as things stand, there is a real chance that the MPC will have to start adjusting the policy rate in the coming meetings, even if the core inflation rate remains close to the target. By the October meeting, there will be at least clarity on the monsoon and its impact on food prices. The nature and extent of policy-rate adjustment will obviously depend on the incoming data. What has helped India and the RBI is that, unlike many countries in the developed world, the inflation rate in India was running below target when the war between the United States (US) and Iran started. However, it has inched up over the past few months and is expected to move up further. 

As argued in this space earlier, the impact of the West Asia crisis on India has been felt more in the currency market than in inflation outcomes — partly because of the limited pass-through of higher energy prices. On the currency front, the RBI had announced several measures to attract foreign flows after the June policy review meeting. The results thus far have been encouraging and about $41 billion has been mobilised. This has helped stabilise the rupee. Foreign portfolio investment has also improved over the past few months, and it would be worth watching if India gets a surplus on the balance of payments this financial year. A lot will depend on how the situation in West Asia evolves and how bond yields in the developed markets, particularly in the US, move. Financial markets are expecting the US Federal Reserve to increase policy interest rates in the coming months, which can put pressure on capital flows with a narrowing yield difference. Although the MPC is not expected to respond to such outcomes, its actions in the context of higher inflation rates could help on the currency front as well.