India’s real rate moment, the cost of delay

Why in the News

The Reserve Bank of India (RBI) has held the repo rate at 5.25% as Consumer Price Index (CPI) inflation rose to 4.82% in August from 4.45% in July, the third consecutive month above the 4% target. Food inflation stands higher at 5.95%, and core inflation has risen to around 4.2%, which places price pressure beyond food alone. The August policy kept a neutral stance and projected inflation for the financial year 2026 to 2027 at around 5%. The latest reading has already moved past that projected trajectory for the year. The tension is that a repo rate which looks restrictive in nominal terms is delivering steadily less restraint in real terms, and it is doing so at a point when credit growth and output growth are both strong rather than weak.

What is the ex ante real policy rate?

1. Definition: The ex ante real policy rate is the repo rate less the inflation the economy expects over the period ahead, not the inflation already recorded in the last print.
2. Why the distinction matters: Monetary policy operates through expected inflation, so subtracting yesterday’s inflation from today’s policy rate gives a number the economy is not actually responding to.
3. The zero point: A repo rate of 5.25% held while inflation expectations move toward 5.25% leaves an ex ante real policy rate of approximately zero.
4. What zero changes: A comfortably positive real policy rate and a zero real policy rate are two different monetary environments, even where the nominal rate on the screen has not moved.

How close is India to a zero real rate?

1. Headline drift above target: Inflation at 4.82% in August, up from 4.45% in July, is the third straight month above the RBI’s 4% target.
2. Food and core moving together: Food inflation at 5.95% sits well above the headline, and core inflation at around 4.2% shows the pressure is broadening rather than concentrating in one basket.
3. Projection already overtaken: The RBI projected inflation for the financial year 2026 to 2027 at around 5% at the August policy, and the latest print has moved beyond that average trajectory within weeks.
4. Market expectations of tightening: The one year Overnight Indexed Swap (OIS) rate, the fixed rate at which market participants exchange a floating overnight rate over a year and therefore a direct read of expected future policy rates, is around 6%.
5. The conditional statement: Sustained momentum in domestic prices combined with an external shock takes India into a zero real interest rate environment.

What external pressures are pushing inflation up?

1. West Asian conflict: Renewed conflict in West Asia has disrupted shipping through the Strait of Hormuz, the channel through which a large share of seaborne crude moves out of the Gulf.
2. Crude above $100: Brent crude has moved above $100 a barrel with prices approaching $110.
3. Currency channel: A weaker rupee raises the domestic price of every imported input irrespective of the dollar price.
4. Global commodity prices: Elevated commodity prices worldwide compound the oil effect across the import basket.
5. Monsoon uncertainty: The monsoon remains an independent source of risk to the food component, which is already the fastest rising part of the index.

Should a supply driven price rise trigger a monetary response?

1. The case against acting: A central bank should not raise rates simply because oil prices have increased, since a supply shock raises measured prices without excess demand behind it.
2. The case for acting: A temporary price rise becomes permanent once it is embedded in expectations, wages, prices and credit, and that is the risk a central bank cannot leave untested.
3. Demand is not weak: Gross Domestic Product (GDP) growth is running at 7.8%, so the standard argument that a falling real rate simply revives a slack economy does not describe current conditions.
4. Amplification rather than neutralisation: A falling real rate stimulates demand and credit where the economy is operating below capacity. With demand already healthy and the shock coming from supply and expectations, the same mechanism amplifies inflation instead.

Why does a near zero real rate not reach borrowers and savers alike?

1. Credit growth: Bank credit grew 19.1% year on year at the end of August and remains exceptionally strong.
2. Deposit growth and its composition: Deposits grew 17.8% at the end of August, the fastest pace in a decade, and much of that reflects foreign currency inflows under the RBI’s special Foreign Currency Non Resident Bank, or FCNR(B), mobilisation scheme, under which banks raise dollar denominated deposits from non residents on concessional terms. It does not establish that domestic households have become more willing to hold conventional deposits.
3. Credit deposit ratio: The ratio stood at around 80.3% at the end of August, so banks face strong credit demand while competing for stable domestic deposits.
4. Savers have exits: Households hold alternatives to bank deposits in mutual funds and equities, and a falling real return on deposits shifts them toward market linked assets, gold and other inflation hedges.
5. The recorded precedent: RBI research on the earlier inflation episode found that rising inflation and inflation expectations cut the real return on household financial savings. Real returns on savings instruments turned negative across 2010 to 2013, household financial savings weakened, and gold demand rose, with the correlation between gold imports and household inflation expectations estimated at 0.83 over that period.

Challenges to the ex ante real policy rate as a policy guide

1. Expectations are estimated, not observed: The ex ante real rate rests on an inflation expectation that no market price reports directly, so the rate the committee acts on is itself a judgement. Eg. The RBI’s Inflation Expectations Survey of Households has run persistently above realised inflation.
   The Fix: Publish a single headline expectations series alongside each policy statement, so the real rate the committee is acting on is visible to the market.
2. Supply shocks distort the signal: An imported price rise lifts measured inflation with no excess demand behind it, so a rate response tightens domestic activity that did not cause the problem. Eg. The 2022 conflict in Ukraine pushed Indian headline inflation past 7% on energy and edible oil alone.
   The Fix: State the persistence test on core inflation separately from the headline print in the policy rationale, and act on the former.
3. Transmission lags defeat timing: A repo change reaches lending and deposit rates over several quarters, so a move calibrated to today’s reading lands on a different economy. Eg. The external benchmark linked lending rate regime was introduced in October 2019 because pass through under the marginal cost of funds based lending rate was slow and partial.
   The Fix: Extend external benchmark linking to the loan categories still priced off the marginal cost of funds based lending rate.
4. Fiscal borrowing sets a competing rate: Heavy government issuance holds the term structure up, so the policy rate is not the only rate deciding the cost of credit. Eg. Benchmark ten year government securities have traded above the policy corridor irrespective of the stance the RBI announced.
   The Fix: Anchor annual borrowing to the announced debt to GDP path, so that the policy rate rather than issuance volume drives the cost of longer term credit.

Conclusion

The direction of the next move is settled. Inflation is rising toward the policy rate while growth and credit both remain strong, which leaves the policy rate doing less real work each month it is held. Timing is the instrument still in the RBI’s hands, and a timely 25 basis point adjustment ultimately costs less than a delayed 50 basis point correction. What to watch is whether the Monetary Policy Committee acts on the expectations reading or waits for a further headline print to confirm it.

What is Monetary Policy?

1. About: Monetary policy is the process by which the RBI controls money supply, interest rates and credit to achieve price stability, growth and financial stability.
2. Statutory framework: The Monetary Policy Framework Agreement of 2015 made inflation targeting the primary objective, and the CPI Combined series compiled by the National Statistical Office is the target measure.
3. Target and committee: The 4% target with a band of plus or minus 2 percentage points has been retained for the April 2026 to March 2031 period, and a six member Monetary Policy Committee sets the repo rate.
4. Accountability trigger: A breach of the 2% to 6% band for three consecutive quarters obliges the RBI to submit a report to the government explaining the failure and the corrective action.

Matching Previous Year Question

“What are the causes of persistent high food inflation in India? Comment on the effectiveness of the monetary policy of the RBI to control this type of inflation.”