RBI Policy Review: August Rate Hike Pivot Possible if Rupee and Foreign Flows Show Limited Improvement

RBI Monetary Policy Review: Central Bank Stays on Hold, Warns of Inflation Risks

The Reserve Bank of India's (RBI) Monetary Policy Committee (MPC) has chosen to stay on hold, keeping the policy repo rate unchanged at 5.25 percent, while also maintaining the policy stance at Neutral. This decision was made despite rising inflationary expectations and a sharp depreciation of the Indian rupee (INR).

The RBI Governor highlighted the risks to the Indian economy emanating from the prolonged middle east conflict, surge in oil prices, and trade/supply disruptions. He also acknowledged that global central banks have turned cautious and started pivoting towards monetary policy tightening, creating bearishness in the global fixed income markets.

On the domestic front, the RBI has delivered a double whammy by bringing down its growth projections and raising sharply its inflation projections. The revised projection for year-over-year (YoY) GDP growth for FY27 is now 6.6 percent (from 6.9 percent), with the impact being felt in Q3 (6.3 percent) and Q4 (6.5 percent). The Governor emphasized that the overall economic situation continues to be resilient, and India has so far withstood the conflict-related pressures.

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However, going ahead, the rise in energy prices (and their pass-through into retail fuel prices) + supply constraints will weigh on growth. Additionally, the possibility of a sub-normal South-West monsoon and El Nino will adversely impact the food outlook, agricultural production, and rural demand.

On the inflation front, the situation appears to be more grim, as the Consumer Price Index (CPI) forecasts for FY27 have been raised rather sharply, compared to the RBI's previous assessment. While Q1 YoY forecast has been tweaked marginally up to 4.2 percent (from 4.0 percent), the real jump comes from Q2 (5.1 percent from earlier 4.4 percent) and going even higher in Q3 (5.9 percent from 5.2 percent) before coming off slightly in Q4 (5.4 percent from 4.7 percent). Overall, the impact in FY27 is expected to be 5.1 percent (from 4.6 percent).

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Although CPI has so far been contained within the RBI's tolerance band, this has been primarily due to prices of fuel prices being kept steady by the Government – which is no longer the case. Higher energy prices and higher input prices will put upward pressure on the CPI; food inflation will also come under pressure.

In terms of liquidity management, the Governor emphasized that the RBI has been (and will continue to be) active in ensuring appropriate liquidity in the banking system.

The RBI Governor announced several concrete measures to address the ailing Rupee and the 'not-so-positive' Foreign Portfolio Investors (FPI) sentiment for India. These measures include:

• Expansion of the universe of specified Government Securities under the Fully Accessible Route (FAR)
• Increase in limits for investment by Non-Resident Indians/Overseas Citizens of India (NRIs/OCIs) (without Sebi registration) in listed equity instruments
• A concessional forex swap till 30 September 2026
• Concession in the hedging cost for authorized Dealer Banks for raising 3-5 year Foreign Currency Non-Resident (B) deposits
• Restoration of the period for realization of export proceeds to 9 months

The Governor reiterated that the RBI's stance related to forex management remains unchanged – no specific target or band for the INR, and essentially allowing market forces to determine the movement of the INR.

Key takeaways

Looking at the tone of the policy and the Governor's speech, it appears that the MPC has been balanced in its approach. However, in the inflation-growth risk tradeoff (higher inflation and lower growth outlook), risks to inflation presently seem to outweigh the risks to growth.

The bazooka of measures announced in the external sector should help improve the sentiment for the INR in the near-term (prevent further depreciation and possibly help in some recovery). The Government has also acted swiftly and provided tax benefits to FPI investments in Government Securities (zero tax on interest and capital gains and removal of withholding tax). This should help increase the FPI activity in the fixed income markets.

At the current juncture, monetary policy appears to be behind the curve, and one can expect 75-100 bps cumulative rate hikes over the next 3-4 monetary policies. While the near-term sentiment for domestic yields can improve (relief rally + forex measures), the eventual path for yield curves would be a hardening bias as the RBI MPC changes the policy direction in due course.