RBI raises repo rate for first time in nearly four years: Why it matters

The Reserve Bank of India has raised its benchmark repo rate for the first time in nearly four years. But why has the central bank decided to increase borrowing costs now, and what does the move mean for inflation, economic growth and borrowers?

The Monetary Policy Committee (MPC) on Wednesday unanimously raised the repo rate by 25 basis points to 5.5 per cent.

The RBI also changed its policy stance from ‘neutral’ to ‘calibrated tightening’, indicating that further rate increases remain possible depending on how inflation and economic growth develop.

RBI Governor Sanjay Malhotra said the extent and timing of any further increases would depend on actual inflation and growth data.

At a press conference later, Malhotra described calibrated tightening as a “milder form of tightening, (which is) more data dependent than pre-determined.”

Why did the RBI raise the repo rate?

The immediate concern is inflation.

Retail inflation rose to 4.82 per cent in August from 4.45 per cent in the previous month. It remained above the RBI’s 4 per cent medium-term target for a third consecutive month.

Higher fuel and food prices are spreading through the economy, with nearly half of the consumer basket seeing inflation above 4 per cent.

“Headline CPI (consumer) inflation is expected to average almost 5.8% in the next three quarters,” Malhotra said. “In this milieu, recalibrating the policy rate is imperative”.

Malhotra also said there is some evidence of elevated inflation expectations and broadening price pressures, adding that “inflation and its outlook are not benign as they were last year.”

The RBI has now raised its inflation forecast to 5.2 per cent from its earlier forecast of 5 per cent. Core inflation, which excludes volatile food and fuel prices, is seen at 4.4 per cent from 4.3 per cent earlier.

What is making inflation more difficult to control?

The continuing West Asia crisis is adding another layer of pressure, particularly through oil prices.

India has joined major central banks in raising interest rates as higher oil prices triggered by the Iran war fuel inflation, squeeze purchasing power and weigh on currencies.

Weak monsoon rains linked to El Niño have also compounded price pressures in Asia’s third-largest economy.

The RBI’s move comes as other major central banks have also raised interest rates.

Last month, the US Fed effected a 25 basis points rate hike to rein in inflation brought on by spiralling oil prices and other factors.

Prior to the Fed, the European Central Bank too raised its key interest rate by 25 basis points.

Why can the RBI raise rates now?

One reason is that economic growth remains strong.

The central bank expects GDP to expand 7.1 per cent in the current financial year, 40 basis points higher than its earlier projection.

GDP growth for the April-June quarter stood at 7.8 per cent, well above the central bank’s forecast of 7 per cent.

The strong growth gives the RBI greater room to increase borrowing costs for consumers and businesses while focusing on inflation.

Malhotra said there is limited evidence of demand-side pressures in inflation so far but risks exist “in view of strong growth in monetary and credit aggregates.”

India’s bank credit growth has soared in the past few months and grew by 18.8 per cent in October, reflecting strong demand.

What does ‘calibrated tightening’ mean?

The change in stance is important because it indicates a shift in the RBI’s policy direction.

The central bank moved from ‘neutral’ to ‘calibrated tightening’. However, this does not mean that a fixed number of future rate hikes has been announced.

Malhotra said the extent and timing of further increases would depend on actual inflation and growth data.

He later described the new stance as a “milder form of tightening, (which is) more data dependent than pre-determined.”

That means the RBI will continue to assess inflation, economic growth and the spread of price pressures before deciding its next move.

Will the RBI raise rates again?

The answer will depend on how inflation and growth evolve.

Analysts are divided on how far the central bank will raise rates.

“We expect another 50-75 basis points in rate hikes over the coming months,” said Sakshi Gupta, economist at HDFC Bank. “In the event that the West Asia conflict lingers and oil prices remain elevated, the inflation risk could increase further, necessitating a more aggressive tightening cycle,” Gupta said.

Krishna Bhimavarapu, Asia pacific economist at State Street Investment Management in Bengaluru, expects the latest move to be the beginning of a larger tightening cycle.

“The RBI has taken a sensible first step with a 25-bps hike, our base case remains for 100 bps of cumulative tightening over this cycle,” he said.

“The ultimate magnitude will depend on how the global energy shock, food inflation broader inflation dynamics and the global tightening cycle evolve in the coming quarters,” he said.

What does the repo rate hike mean for borrowers?

The repo rate is the rate at which the RBI lends to banks. When the policy rate rises, borrowing costs can also increase.

Home loans, vehicle loans and corporate loans would become expensive, while EMIs for existing borrowers would also go up.

The impact on individual borrowers will depend on how banks and lenders transmit the increase in the policy rate to their lending rates.

What happened to the rupee and markets?

The rate decision came as the rupee remained under pressure.

India’s benchmark 10-year bond yield was slightly higher at 7.2269 per cent, while the rupee currency hovered around its previous close at 96.43 against the US dollar. It continues to trade near record lows.

The benchmark Nifty 50 Index was down 0.3 per cent but recovered from the day’s lows.

The RBI has also been managing liquidity in the banking system.

Why did the RBI not raise the reserve ratio?

The central bank did not announce additional measures such as a hike in the reserve ratio to drain surplus liquidity from the banking system, contrary to market expectations.

“The Reserve Bank will use an appropriate mix of liquidity management tools,” Malhotra said, later adding that a reserve ratio hike would be the “least preferred” option.

So far, the RBI has used bond sales and longer-term FX swaps to drain liquidity.

Schemes to draw dollars and support the rupee drew close to $144 billion as of mid-September, according to central bank data. These dollars, swapped with the central bank, led to a flood of liquidity which peaked at a record 11.16 trillion rupees at the beginning of September.

Commenting on the persistent rupee weakness despite large inflows via these schemes, Malhotra said markets can be “irrational” in the short term, adding the rupee “might be undervalued”.

Why is this rate hike important?

The latest decision marks a reversal from the RBI’s earlier policy direction.

The last repo rate hike was in February 2023, when the RBI raised the rate by 0.25 per cent to 6.50 per cent. It kept the rate unchanged through 2023-24 before beginning its rate-cut cycle in 2025.

The six-member rate panel voted unanimously for the latest increase, while nearly 60 per cent of economists in a Reuters poll had expected a 25 basis points increase in the repo rate.

The key question now is how long inflation remains elevated and whether the West Asia crisis continues to push up oil prices.

The RBI’s next moves will depend on the actual inflation and growth data, while the central bank also weighs food prices, core inflation, global monetary tightening and domestic credit growth.

(With inputs from agencies)