A 25-basis-point increase in the repo rate was widely expected, and the MPC delivered on the same. However, a majority of the MPC went ahead and changed the stance to ‘calibrated tightening’ from ‘neutral’, which should be read as a hawkish signal. The RBI’s growth andinflation projections too have been revised higher for 2026–27, with a meaningful upward shift in 2027–28 headline inflation to 5%. This clearly signals that the repo rate is heading higher in the next few policy decisions. But what is more important now is where the terminal rate should settle in the cycle and the quantum of the liquidity surplus.

Given that growth has averaged around 8% over the last four quarters and high-frequency indicators point to sustained growth in the July–September quarter, the RBI has revised its 2026–27 growth estimate to 7.1% (ICICI: 7.1%) from 6.7%, with the same holding up at 7% in 2027–28. Growth is driven by resilient consumption along with an improvement in exports and investments in data centres, the power sector and machinery.

At the same time, rural demand is likely to moderate on the back of a weaker monsoon this year, and there are signs of the same visible in the FMCG sector and recent tractor dispatches. But the recent improvement in credit offtake and a favourable outlook imply that India is far better positioned to ward off global risks.

On the inflation front, the RBI has increased its inflation forecast both for 2026–27 and 2027–28. While the inflation forecast for 2026–27 has been raised to 5.2% from 5% earlier, that for 2027–28 has been raised to 5%. At the beginning of the year, headline inflation for both 2026–27 and 2027–28 was estimated at 4.6%.

However, the upward revision in the inflation forecast is largely a result of supply-side factors (food and fuel) rather than demand-side factors (core inflation). Core inflation for the year is unchanged at 4.4% now versus at the beginning of the year. This is also seen in diffusion indices for food and core inflation, wherein around half of food items are now showing price increases of more than 4% in comparison with only one-fifth of core items showing a similar increase.

Supply Pressures

Food inflation is rising on the back of a low base and a deficient monsoon this year. Globally, grain prices are rising because of El Niño and disruptions in the Black Sea. Domestic retail prices of fuel products too have been raised, which has been accompanied by a much higher increase in non-administered prices. The supply-driven cost increases are visible in inflation internals as well, given that producer prices are rising at more than twice the pace of headline CPI.

In the case of core (excluding precious metals), a sequential uptick is visible with an annualised run rate of 4.8% over the last five months. But inflation is yet to get entrenched and broad-based since firms are yet to pass on the entire magnitude of input costs, as seen in the moderation in margins in the April–June quarter. Hence, given the heightened risks of pass-through because of higher growth, the MPC has changed its stance to ‘calibrated tightening’, which signals that the next action is either a hike or a pause.

This brings us to the question of the terminal policy rate and the magnitude of the liquidity surplus in the cycle.

Given that the inflation trajectory is mostly driven by supply-side factors, a terminal policy rate of 6% should suffice. This is based on the evidence that in the medium to long term, headline inflation gravitates towards core inflation, which is estimated at 4.4% in 2026–27 and should remain in the 4–4.5% range even next year.

Given the RBI’s inflation trajectory of 5.6% in April–June 2027–28, headline inflation should move towards core inflation in the second half of 2027–28. On the basis of these projections, the real policy rate should be in the 1.4–1.9% range in the second half of 2027–28. These are current projections, and if price pressures get broad-based or supply-driven shocks show an even bigger uptick, the terminal rate has to be calibrated accordingly.

Liquidity Choices

In the case of liquidity, the year started with a durable liquidity surplus of ₹5 trillion, and in mid-September the same peaked at around ₹14 trillion. The same is around ₹10.5 trillion–₹11 trillion now, and given the demand for durable liquidity because of endogenous factors (currency, reserve balances), an additional ₹2 trillion of durable liquidity should be taken out by exogenous tools (spot intervention, sell-buy swaps and OMOs). This should make sure that the liquidity surplus is in the 0.5–1% band by March 2027 and should ensure that there are minimal inflationary risks arising from excess liquidity.

In terms of the choice of instruments for absorbing excess liquidity, the bulk of absorption has been done via sell-buy swaps followed by spot intervention and OMO sales. The same has led to an increase in forward premia, which has made domestic interest rates or credit attractive as against the landed cost of foreign money and thus driven domestic credit growth higher. Going forward, too, the preference seems to be more of the same.

Given the current backdrop, there are two-sided risks to the inflation trajectory and thus the terminal policy rate. On the one side is the efficient supply-side management by the government since the implementation of the flexible inflation targeting regime. On the other side is the risk of elevated global energy prices and eventual pass-through into domestic prices, which pushes supply-driven inflation even higher.