After US Fed and others, will RBI also raise interest rates in Oct?

Why in the News

The Federal Open Market Committee (FOMC), the rate setting panel of the US central bank, has raised the federal funds rate target range by 25 basis points to 3.75% to 4%, its first increase in three years. The decision reversed the expectation that a new Chair at the helm of the Federal Reserve would push forward the US President’s agenda of lower interest rates, and all 12 FOMC members, including the new Chair, voted for the increase. The move is one of several, with the European Central Bank, the UAE and Bahrain all raising rates within days. The tension now sits with India. The Reserve Bank of India (RBI) is mandated to hold consumer price inflation at 4%, retail inflation has run above target for three straight months, and its Monetary Policy Committee (MPC) meets from 5 to 7 October.

What is the Monetary Policy Committee (MPC)?

1. What it is: The statutory committee of the Reserve Bank of India that decides the repo rate, the rate at which the central bank lends to commercial banks against government securities.
2. Its mandate: It is required to target consumer price inflation of 4%, within a tolerance band of 2% to 6%.
3. How the rate works: A higher repo rate raises the cost of funds for banks, which passes into lending rates and is intended to compress demand and with it price pressure.

Why did the US Federal Reserve raise rates?

1. The stated inflation reason: The FOMC said “inflation remains elevated” and that the decision to increase rates will support a “timelier return” to the 2% inflation target, closing with the line that the Committee “will deliver price stability”.
2. The growth reading behind it: The FOMC described US economic activity as expanding at a “solid” pace, with domestic spending resilient, productivity growth strong and capital investment robust.
3. The labour market reading: Job gains have kept pace with the workforce and the unemployment rate has changed little, which removes the usual argument against tightening.
4. The political objection: The White House called the decision “rather unfortunate” and said it was not backed by a “particularly compelling economic case”, which the unanimous vote nonetheless overrode.

What does the wider round of rate decisions show?

1. The Gulf economies: The central banks of the UAE and Bahrain both raised their main interest rates by 25 basis points, to 3.9% and 4.5% respectively, mirroring the US decision.
2. Japan at a three decade high: The Bank of Japan is widely expected to raise interest rates to 1.25%, the highest in 31 years, on the reading that risks to Japanese inflation are skewed to the topside.
3. The drivers named for Japan: A weak yen raising import prices, no resolution in sight to the West Asia conflict or to traffic through the Strait of Hormuz, and strong artificial intelligence demand adding to goods and services prices.
4. The euro area: The European Central Bank raised interest rates by 25 basis points, noting that upward price pressures caused by the West Asia conflict are set to keep inflation “well above target for an extended period”.
5. The exception: The Bank of England left its policy rate unchanged at 3.75%, so the tightening round is broad rather than universal.

What is happening to prices in India?

1. Across every measure: In August, inflation for households, wholesalers and producers all increased, so the pressure is not confined to the retail basket.
2. The headline number: The Consumer Price Index (CPI) rose 4.82% in August, the third straight month above the 4% target, though still inside the tolerance band.
3. The near term projection: Some economists see CPI inflation jumping to 5.7% in September.
4. The central bank’s own path: The RBI expects CPI inflation to average 4.7% in July to September, 5.9% in October to December, 5.5% in January to March 2027 and 5.3% in April to June 2027, so its own forecast breaches the upper tolerance band in the current quarter.

Has price pressure become generalised, and does the MPC accept that?

1. The MPC’s August reading: The Committee said in August that there were “little signs of” a generalisation of price pressures, which is the reading that supported holding the rate.
2. The contrary assessment: The Group Chief Economic Adviser of the State Bank of India holds that the process of generalisation of price pressures has already started.
3. The projected peak on that view: CPI inflation may cross the 6.5% mark before dropping to less than 6% in early 2027, which places it outside the tolerance band rather than merely above target.
4. The prescription that follows: A 25 basis point increase at each of the October and December MPC meetings, followed by a pause to take stock against incoming data.

Challenges to a rate hike by the RBI

1. Supply driven price pressure: The increase is coming through imported energy and the West Asia conflict, and a policy rate acts on domestic demand rather than on an external supply shock. Eg. Retail inflation in India spiked in 2022 after crude and edible oil prices rose, and the repo rate was raised by 250 basis points over the following year without the shock itself abating.
   The Fix: Pair the rate action with supply measures on the affected commodities, such as duty adjustments and buffer releases, so the instrument matches the source of the pressure.
2. Transmission lag: Policy rate changes reach lending and deposit rates over several quarters, so an October increase acts on prices well after the projected peak has passed. Eg. Banks repriced external benchmark linked loans within a quarter during the 2022 tightening while deposit rates moved far more slowly.
   The Fix: Expand the share of loans linked to an external benchmark so the increase reaches borrowers in the quarter it is announced.
3. Cost to growth and to borrowers: A higher repo rate raises the cost of housing and working capital loans at a time when the price shock is already compressing household budgets. Eg. Home loan instalments rose across banks through the 2022 to 2023 tightening cycle.
   The Fix: Sequence the increase in two smaller steps with a stated pause, so borrowers and firms can price the path rather than the level alone.
4. Limited currency benefit: Raising rates while major central banks are raising theirs leaves the interest differential roughly unchanged, so the rupee gains little support from the move. Eg. The rupee weakened through 2022 despite repeated repo rate increases, because the Federal Reserve was tightening faster.
   The Fix: Rely on reserve management and rupee settlement arrangements for exchange rate support, rather than loading that job onto the policy rate.

Conclusion

The question is no longer whether India is an exception to a global tightening round, since every major central bank except one has moved in the same direction within a week. It is whether the MPC accepts that price pressure has generalised, which is the reading it rejected in August and which its own forecast for October to December now strains. The decision window is 5 to 7 October, and a 25 basis point increase would be the first in three and a half years and would take the repo rate to 5.5%.

Back2Basics: Federal Open Market Committee (FOMC)

1. What it is: The monetary policy body of the US Federal Reserve System, which sets the target range for the federal funds rate.
2. Composition: Twelve voting members, comprising the seven members of the Board of Governors, the President of the Federal Reserve Bank of New York, and four other regional Reserve Bank presidents serving on rotation.
3. Frequency: It holds eight scheduled meetings a year and issues a statement with each decision.
4. What the federal funds rate is: The rate at which US banks lend reserve balances to each other overnight, which anchors short term borrowing costs across the dollar system.

Matching Previous Year Question

“[2017] Which of the following statements is/are correct regarding the Monetary Policy Committee (MPC)? 1. It decides the RBI’s benchmark interest rates. 2. It is a 12-member body including the Governor of RBI and is reconstituted every year. 3. It functions under the chairmanship of the Union Finance Minister. Select the correct answer using the code given below: (a) 1 only (b) 1 and 2 only (c) 3 only (d) 2 and 3 only Answer: (a)”