With Exchange Rate Pressures Easing, RBI Missed a Chance to Rebuild Monetary Space

The Reserve Bank of India’s monetary policy announcement of August 5, 2026, was disappointing because of its dovish communication. It was certainly not “central-bankish” in acknowledging the underlying risks to inflation. To my mind, the time was ripe to start a modest rate hike cycle to rebuild monetary space, as the extreme stress prevailing during the June policy meeting had been leashed by the very effective capital flow measures taken by the central bank.

Since then, the CPI, on a sequential basis, has shown a clear uptick in price momentum, making it important for the RBI to prioritise inflation targeting over exchange rate defence.*

Worrisome inflation trends soft-pedalled

For the combined CPI, the month-on-month increase jumped from 0.27% in April to 0.75% in May and further to 1.03% in June. Ordinarily, in a typical month, less than 10% of the 358 items in the CPI basket display such strong momentum as the aggregate index has done now.

Even when seasonally adjusted, MoM price increases showed a pronounced acceleration. There is some evidence that price increases are spreading across a wider set of commodities in the CPI basket, indicating that the broadening of inflationary process across commodities may already have begun, even as year-on-year core inflation remains muted relative to the inflation target of 4%.

The Monetary Policy Committee (MPC) must pay close attention to the momentum of price increases rather than simply the level of inflation, as year-on-year measures can be deceptive. Inflation can quickly accelerate from very low levels if momentum is high, leaving little time for monetary policy to act, given that monetary transmission operates with long and variable lags.

If creating monetary space for the future was not the policymakers’ concern, one can still understand if the MPC consciously decided to look through the near-term build-up in inflationary pressures in the hope that they would ease after another four months. However, there is a probability that the ultra-dovish communication accompanying the decision could come to haunt the MPC should inflation turn sticky and a change in the global interest rate cycle warrant rate hikes later this year.    

Two inflation angles that seem to have been missed out

Two things deserved particular attention of the MPC. First, headline inflation stood at 4.38% in June, already above the target, and the RBI’s own baseline forecasts suggest that inflation this year will average 5.9% in October-December.

Moreover, the RBI’s fan chart projections, as gleaned from the chart in the MPC statement, suggest that, even at a 50% confidence interval, realised inflation could average as high as 6.8% in the third quarter and remain as high as 6.5% by the first quarter of 2027-28.

The Governor alluded to the GDP fan chart at his policy press conference. However, the inflation fan chart is even more revealing. The fan chart clearly shows the possibility that inflation may breach the upper tolerance level of 6% for three successive quarters, which constitutes a “failure” under the inflation-targeting framework. Section 45ZN of the RBI Act requires the RBI to submit a report to the Government of India in such events stating (i) the reasons for failure to achieve the inflation target, (ii) remedial actions proposed by the Bank, and (iii) its estimate of the period within which the inflation target will be achieved through the timely implementation of those remedial actions.

Apparently, the RBI has pinned too much faith in its baseline projections, which suggest that inflation is likely to breach the upper tolerance level of 6% in October but then moderate to 5.3% by April-June of 2027-28. If it is lucky and inflation undershoots projections, it may still escape with minimal damage. This may, however, require peace in the Middle East and between Russia and Ukraine, as well as Donald Trump refraining from renewed trade tariffs.

It may also require no further climatic disruptions in India so that the country can weather the El Niño-led shortfall in rains which during the current monsoon season is cumulatively running at 11% below the Long Period Average.

An all-India drought year is defined as an overall rainfall deficiency of more than 10% from the long period average (LPA), combined with more than 20% of the country's area experiencing moderate or severe drought conditions (requiring at least 26% shortfall from the LPA). Irrespective of whether this ultimately qualifies as an all-India drought year, food inflation pressures could still intensify, with water levels in 166 reservoirs running 35% below last year’s level at the end of July and unlikely to reach full capacity by the end of the monsoon season.       

Even if one considers only the baseline inflation forecasts, they still imply that inflation is likely to drift away from the 4% inflation target and stay closer to the upper end of the tolerance band than to the target itself for about a full year. Furthermore, India’s inflation target is already higher than those of several peers, such as the 3% in case of Brazil, Mexico and the Philippines, while Thailand’s target is still lower.

Second, there is a considerable risk that a sustained departure from the target can result in inflation expectations becoming unanchored. Both the three-month-ahead and one-year-ahead inflation expectations captured by the RBI’s Inflation Expectations Survey of Households had risen sharply over the previous three rounds before flattening at an elevated level in the current round. Capacity utilisation rates are tracking above their long-term average and, with surplus capacity shrinking, inflation can return faster than expected once the confidence levels improve. Firms are also in the process of passing on cost-push inflation, as their profit margins are under pressure.

All this could lead to further generalisation of inflation, making it even more difficult to contain. Over the last two months, considerable price pressures have been felt in food, food-processing services, pan and tobacco, clothing, furniture, furnishings, footwear, household appliances, glassware, tableware, household utensils and personal transport equipment. This price rise cannot be attributed solely to supply-side shocks.

Central banks always find it problematic to respond to cost-push inflation and can look through such shocks if they are expected to be temporary. However, the RBI’s own forecast and the internals of the inflation data suggest that this shock is unlikely to be temporary or self-correcting. The spark may have been cost-push inflation, but as price increases spread, monetary policy will eventually have a role to play. Handling a cost-push inflationary shock is far easier than dealing with stagflation, and hiking interest rates is inevitable if growth remains strong.

If the generalisation trend continues over the next two months, there will be no choice but for the RBI to hike policy rates quickly to get ahead of the curve. It therefore raises the question of why the RBI needed to adopt such dovish communication and risk misleading the markets, especially when near-term exchange rate pressures have abated. Such dovishness might even lead to increased forward premia or a revival of funds going underweight on the rupee. A detailed discussion of the exchange rate is best left for another day.   

Growth appears robust, credit growth remains strong

While debate may still linger over the quality of India’s GDP data, there is little doubt that activity levels in the economy have withstood the energy shock. Growth could therefore surprise on the upside, shifting the growth-inflation trade-off decisively in favour of addressing inflation. Bank credit growth stood at a stupendous 17.7% year-on-year in mid-July and is generally a very good leading indicator of business cycles and GDP growth. Moreover, sectoral deployment of credit data suggests that credit growth is now exceptionally broad-based.

Unless there is doubt about the quality of data, there is a strong case for rebuilding policy buffers through greater monetary space, counter-cyclical fiscal policies to create some more space, and counter-cyclical capital buffers and other macroprudential measures to deal with future downturns and financial stability risks.

Real deposit rates have fallen 100 bps below neutral rates

However, policy is drifting. After a 125 bps reduction in policy rates between February 2023 and December 2025, the RBI has been on hold this year and the policy rate in real terms has turned negative, well below the RBI’s estimated midpoint neutral policy interest rate of 1.65%. The weighted average real deposit rate on fresh rupee term loans was just 5.99% in June 2026, which implies that with expected 5.3% inflation rate in the first quarter next year, the saver gets a meagre 0.69% real rateon bank deposits that neither covers term premia, nor the risk premia. This can disincentivise household savings and widen the savings-investment gap, which, by national accounting identity, is reflected in the current account deficit. 

Paragraph 5 of the Governor’s policy statement was at the heart of the ultra-dovish communication and could certainly have been phrased better. It said that “the realised inflation for the first quarter, however, remained marginally lower than projections, reflecting limited pass-through of cost pressures.” Inflation internals suggest otherwise.

It added that “the higher inflation is mostly on account of fuel and food, with little signs of generalisation of price pressures so far.” This again reflects the folly of RBI analysis relying on year-on-year inflation, while ignoring the momentum of sequential month-on-month changes.

The statement also argued that “core inflation, excluding precious metals, continues to be benign.” It ignores the fact that even the RBI’s full-year core inflation projection is above 4% and could surprise on the upside as price pressures broaden. It also ignores the fact that core inflation, even after stripping out precious metals and jewellery, has registered steady upward momentum over the past five months.

The paragraph concludes by stating that “as projected earlier, headline inflation is expected to rise further in the near term and peak in the October-December period of 2026-27, primarily due to food and fuel, before moderating thereafter”. This completely ignores the price pressures already evident across a wide range of commodities, as outlined earlier under the second inflation concern.

In sum, the time is ripe to reassess the policy stance. The conditions prevailing in June were very different and justified holding rates to avoid precipitating further stress. But with near-term currency pressures behind us and growth appearing robust, there is every reason to return to inflation targeting in both letter and spirit.    

* A Sequel to this piece on defence of exchange will follow
(Views expressed are strictly personal)