RBI likely to hike rates for the first time since February 2023 in battle against inflation

After 21 consecutive monetary policy committee (MPC) meetings without a rate hike, the Reserve Bank of India (RBI) is on October 7 expected to raise the repo rate by 25 basis points to 5.5 percent.

Elevated crude prices, tighter global financial conditions and a weak rupee are complicating the inflation outlook and will likely drive the hike.

With the hike largely priced in, markets will focus on the RBI’s guidance on the pace and depth of the tightening cycle, its inflation and growth assessments and strategy to manage surplus liquidity.

A Moneycontrol poll of 19 market experts found that a majority (15 respondents) expect the MPC to hike the repo rate by 25 basis points, the first interest rate increase since February 2023. Four expect status quo.

While growth remains resilient — at 7.8% in the first quarter — the economy is facing several headwinds, including elevated crude prices, surging global bond yields and a currency under pressure.

Here are five things the market will watch:

Rate path and policy stance

The RBI’s guidance on the rate trajectory could matter more than the 25 bps increase itself. Economists expect the central bank to signal that another hike but differ on whether it will change its stance from neutral.

“This policy is particularly important because it marks the beginning of a rate-hike cycle. The first hike is important for signalling and the market will closely watch the RBI’s commentary for an indication of the length and depth of the cycle,” IDFC First Bank chief economist Gaura Sengupta said. The expectation is of around 75 bps of cumulative hikes through February, she added.

A 25-bps hike could be accompanied by a shift in stance, more towards a hawkish commentary. A hawkish stance indicates the accomodativeness of the MPC towards doing what it takes to maintain growth, whereas a neutral is aligned to balancing inflation.

Inflation projection

The central bank is expected to retain its FY27 inflation projection, though some see an upward revision.

The RBI had lowered its FY27 CPI inflation forecast to 5 percent in the previous review. Retail inflation rose to 4.82 percent in August from 4.45 percent in July.

“Domestic conditions support gradual normalisation of monetary policy with FY27 CPI inflation likely to rise to 5.2 percent,” Sen Gupta said in the Moneycontrol poll, adding inflation remains primarily supply-side led, though core inflation momentum is rising.

The key risk is whether the supply-side shock from higher commodity prices begins feeding into broader inflation.

Growth outlook

The RBI’s growth assessment will be another important signal after the economy expanded at a stronger-than-expected 7.8 percent in the first quarter.

Most economists in the Moneycontrol poll expect the RBI to retain its FY27 real GDP growth forecast at 6.7 percent, though some raised their estimates following a strong Q1.

A resilient economy gives the RBI room to focus on inflation but economists are more cautious about the second half as higher crude prices and tighter global financial conditions weigh on the outlook.

Liquidity management

Liquidity management has emerged as a key part of the policy debate after the RBI moved to absorb the surplus created by large foreign currency non-resident bank (FCNR-B) inflows.

System liquidity, which touched around Rs 12 lakh crore earlier in September, has declined to around Rs 4-6 lakh crore following open market operation (OMO) sales and variable rate reverse repo (VRRR) operations.

The weighted average call rate (WACR), the operating target of monetary policy, has also moved closer to the repo rate. According to the RBI’s latest data, the liquidity surplus in the banking system was at Rs 5.03 lakh crore on October 6.

“The current surplus of around Rs 4 lakh crore is not very high, although core liquidity remains above Rs 10 trillion. Given the market impact of recent OMO sales and FX interventions, a 50-basis-point CRR hike could be more effective in absorbing liquidity,” said Abhishek Upadhyay Co-Head Economics & Fixed Income Research at ICICI Securities Primary Dealership.

External risks

The external environment has become a bigger risk for the RBI, with higher crude prices, elevated US Treasury yields and pressure on the rupee complicating the policy outlook.

Brent crude rose to around $107 a barrel earlier this week, while the 10-year US Treasury yield climbed to 5.2 percent. The rupee also crossed the 96-per-dollar mark, while the benchmark 10-year government bond yield in India breached 7.2 percent. Recent market conditions have kept the focus on the RBI’s response to imported inflation and currency pressures.

The combination of higher oil prices and global yields could put further pressure on the rupee and eventually feed into domestic inflation.

For now, the broad expectation is for a measured start to the rate-hike cycle.