The upcoming Reserve Bank of India Monetary Policy Committee meeting promises to be an eventful one. A wide array of domestic and global factors suggest the stage is set for RBI to pivot to rate hikes, and a 25-bps increase in the repo rate is likely. Growth data has surprised positively, inflation shows signs of broadening out, oil prices have skewed upwards, and developed market central banks, including the US Federal Reserve, are tightening monetary policy. 

Also, domestic monetary conditions have turned easier on the back of a surge in FCNR(B) flows that has flooded the banking system with excess liquidity. That is untimely in the above macro context and requires RBI to lean against the same.

If RBI doesn’t hike at this meeting, expectations may build up for a 50-bps move in the December meeting.

Tactically, it is best to minimise the probability that monetary policy is ‘behind the curve’ as that situation could warrant a higher terminal policy rate ultimately. Why does such a risk need attention?

One, there is no sign the West Asia war is close to resolving, and crude prices have broken out recently. To compare the context with the eruption of the Russia-Ukraine conflict in 2022, the current phase of the war is now more than seven months old. By this time, crude prices had returned to pre-conflict levels in 2022. Refined product prices are also trading at record highs, and that is fanning global inflation pressures.

Two, the US Federal Reserve has restarted rate hikes and that increases the probability that other emerging market central banks will follow suit. The FOMC could potentially hike twice more by the time of its December meeting. That is not the base case, and only one hike is likely this year. But with market pricing showing a greater than one-in-three chance of a hike in October also, RBI could get wrong-footed in the adverse scenario.

Three, inflation optics are poised to worsen sharply in the near term, with CPI inflation seen close to 6% on a year-on-year basis in a couple of months. Moreover, there is a good case to believe price pressures could stay sticky at around those levels till April–June 2027. RBI predicts inflation peaks in October–December at 5.9% and comes down thereafter, but the average for January–June 2027 could well be similar in my view.

Even as RBI’s preferred proxy for underlying inflation (core inflation excluding precious metals, i.e. super core hereafter) is still below 3% on a year-on-year basis, the same likely understates true price pressures. Note this metric would be higher if not for GST cuts from last year, and the adjusted inflation would be closer to 3.5%.

Also, central banks typically prefer to look at sequential price changes to track momentum, and that is tracking much higher. This is not surprising given the wide array of shocks that should spur inflation. These include the energy shock, higher global chip prices (that are boosting prices for a wide array of electronic goods) and El Niño conditions (boosting food inflation).

The above shocks are supply-side in nature, but there are signs of generalisation. In any case, supply shocks have a higher probability of spilling over into broader price pressures in emerging economies like India, where inflation expectations are not as well anchored as in developed economies. The backdrop of strong growth allows greater pricing power to corporates and increases the chances of faster inflation also.

Finally, the 7.8% real GDP growth for the April–June period turned out to be sharply higher than RBI’s estimate of 7% that was put out in August, and growth in the current quarter is also tracking 7.5% despite an adverse base. Growth continues to be broad-based, and that indicates the economy is in a good position to withstand some policy normalisation.

‘Neutral’ Monetary Policy
There is a lot of uncertainty about the outlook for crude prices, and that complicates RBI’s reaction function. But there is a case to believe 3-4 hikes are suitable even if crude prices settle in the $80–100 per barrel range. Such tightening will only partially reverse the cuts delivered in 2025, from the peak repo rate of 6.5% (and more so compared to the peak effective overnight rate of 6.75%). The current growth-inflation backdrop is very different from 2025, when there was a risk the economy could slow abruptly in the face of the US tariff war. And some monetary policy normalisation is required.

Note, real policy rates will be barely positive till the first half of 2027–28, when inflation should average close to 6%. To be sure, as we approach the end of the fiscal year, RBI may prefer to benchmark monetary policy to 2027–28 inflation forecasts. But it is reasonable to expect 2027–28 inflation will also average between 4.5% and 5%. Headline inflation in 2027–28 should converge to core inflation that may reach 4.5% soon.

For the second half of 2027–28, headline inflation may drift lower and average between 4% and 4.5%. But real policy rates will still be 2%, and that is not high. Recall, real policy rates averaged in that same ballpark in the pre-Covid period. Signs that potential growth is higher and an increase in global neutral rates together suggest these policy settings will not be restrictive and growth should stay strong.

CRR Hike
Given the scope for 3–4 hikes, RBI should deliver a hawkish hike. A dovish first hike will confuse markets and dilute the impact of the hike. RBI struggled to control the narrative after the last MPC meeting as well, and it must be more vigilant this time. It is not necessary to change the monetary policy stance to deliver a hawkish message, even if that is most effective. Alternatively, RBI could separately signal that monetary policy is still accommodative, and inflation forecasts could imply more rate hikes are needed to manage the message.

RBI could also pair the repo hike with a 50 bps CRR hike, just like in early 2022. The tool looks more useful now given the bigger excess liquidity and stronger credit growth that together portend faster broad money supply growth and higher inflation. Other liquidity tightening tools, including FX swaps and OMO sales, have far bigger market impact costs, and the RBI must avoid distorting markets as much as possible.