NEW DELHI : Amidst lingering uncertainties led by West Asia conflict, US trade uncertainties and unstable global economic environment, RBI kept the policy rate unchanged at 5.25% and the stance at “Neutral”. Notably, from the tone of the policy it appears that RBI is more comfortable on the macro uncertainty now than it was in the June policy. And not surprisingly as they held rates in June, they have continued to do so now.
The lingering question now is – as the geopolitical uncertainties are far from moderating, is RBI’s positioning of a “reactive” versus a “proactive” stance justified? If RBI is taking a cue from the US Fed on absorbing market reaction rather than feeding market reaction, then markets are continuing a price a 50 bp hike in this cycle.
While the pause was anticipated, what was the primary reason from RBI to hold rates? A benign core inflation. Notably the benign core inflation is giving RBI the comfort as they seek greater clarity on the path and composition of inflation before taking any rate action. With the stance maintained at “neutral”, we can expect RBI to act via non-monetary tools, namely, liquidity in the October policy. The change in growth/inflation outlook is more from a positive shift in near-term inflation and growth outlook suggests that RBI, while not confident is also not diffident.
What is the outlook? The next policy announcement is on October 7, just after the close of FCNR (B) and the start of the festive season. Unless geo-politics escalate meaningfully, RBI may not act on rates unless the conflict escalates once again.
The tone of the policy is less conservative versus June. Growth is more comfortable and inflation focus has shifted to a benign core versus headline. Five important takeaways from the policy were:
1. Watch for 2nd order effects before action, which mean support for the current pause
2. Inflation estimates marginally downward by 10 bps. For FY 27, estimates were revised to 5.0% from 5.1%.
- In June, the policy statement noted higher pass-through of input costs, this policy statement while noting the risks of second-round impact placed a greater emphasis on core inflation remaining benign.
- Core inflation for FY27 is projected at 4.3%. Core excl.
- As they didn’t hike repo in June, a slightly lower headline outlook gives them the comfort to hold the rate, especially if the near-term risks are not significant.
3. a) Growth rate was revised upwards by 10 bps in the August policy statement.
- b) In June the policy statement noted “downside risk to growth” while now “the risks are evenly balanced”. Again, space to hold as growth rate is not rising in an worrying manner.
4. Transmission of rates have halted with hardening in deposit and credit rates since March-April. This raises the question if RBI is behind the curve in raising rates.
5. Liquidity: In the press conference Governor said that surplus is only in the short term and will get absorbed. Liquidity is expected to peak in September. Possibly there will be liquidity tightening measures in October. However, if the view is that RBI will keep rates unchanged until December, they could let liquidity run its course via VRRR measures versus CRR hike. If geopolitics forces RBI’s hand into a rate hike, then it will have to tighten liquidity to allow transmission.
What are the factors that support RBI’s decision today?
- US Fed is unlikely to hike soon even if other global central banks like ECB, RBA, RBNZ and subsequently BoJ hike rates.
- El-Nino effects are not yet fully entrenched on inflation. Food price effects can partially be negated by government supply side actions.
- Expectation that the ceasefire 3.0 will hold and not escalate as US mid-term elections are approaching. In the June policy RBI had estimated $95/bbl for crude which has since then moderated except for a short phase of escalation.
- in a situation when liquidity can turn into meaningful surplus led by FCNR (B) flows, rate actions may not be effective. Therefore, a hike can come once RBI negates the liquidity impact.
What are the factors that question RBI’s decision today?
- No mention of high WPI in this policy statement. In June policy, RBI noted the sharp spike in WPI. As WPI continues to remain closer to double digits, the risk of pass-through remains high.
- Rates can move contrary to policy expectations especially if US bond yields rise. Bond yields may not go by RBI direction on rates, if the Indian central bank like the US Fed becomes reactive to market signals, rather than be proactive.
- Global central banks, especially Asian central banks, pursue rate hikes and thus build pressure on the Rupee.
- Three-month Overnight Index Swap fell from 5.44% to 5.38%, not pricing in much of a hike while the 6M OIS is pricing in one hike to 5.5%, however, moderating by 7bps. One-year OIS at 5.76% has priced in two hikes in this cycle.
While the odds in favour of hike are as good in favour of pause, the “debatable” question is whether the second-order effects will get entrenched. We think that beyond headline rates, price level of crude and other commodities like chemicals, fertilizers, crude derivatives, metals remain high, posing significant second-order risks. In addition, refining capacities remain constrained, leaving end prices higher. Refining spreads remain at a historic high. Inflation risks are not dissipating easily, globally or locally.
The catalyst is RBI reserves
Reserves stood at $692.9 billion as of July 31, 2026. A $21 billion accretion from June 12 in the backdrop of $41 billion accretion in special deposits. The gap is likely explained by unwinding of near-term maturities of the short forward book of $103 billion as of June 30. In addition, RBI has also used reserves to defend volatility. Recall 2013 was followed up with 75 bps of repo hike and special deposits accruing to reserves. This time it is different. A reactive versus proactive approach will be tested.
In the scenario when global yields are rising (fiscal pressures, credibility risks, uncertainty), market reaction (yields) may rise even without a rate hike. That may create some frictions in the economy, especially in the banking sector. RBI did note that the transmission has already moderated. Amidst a 6.5 – 7% growth, a 50 bps rate hike in the cycle will not impede growth if the expectations are already transmitted in the channel. As the saying goes – “A bird in the hand is worth two in the bush”, a rate hike today may be worth two tomorrow.
