Why RBI Is Playing the Wait-and-Watch Game on Interest Rates

The Monetary Policy Committee (MPC) of the Reserve Bank of India began its three-day policy meeting on Monday amid volatility in the global oil market, as the US-Iran conflict continues to fuel uncertainty in global financial markets.

Most market participants and economists are expecting the rate-setting panel of the RBI to keep the benchmark repo rate unchanged at 5.25% and maintain a neutral stance.

"The biggest challenge for economists currently is to understand what we do not understand. The data shows aggregate indicators doing fine while ground reality may be different," Indranil Pan, chief economist at Yes Bank, said.

MPC Faces Inflation-Growth Balancing Act

Policymakers are continuing to walk a tightrope amid a tricky situation, with upside risks to inflation and downside risks to growth. At its June policy meeting, the RBI lowered its GDP growth projection for FY27 to 6.6% from 6.9% in the previous meeting.

Meanwhile, inflation was projected at 5.1%, up from 4.6%, higher than the RBI's inflation target of 4%, although within the tolerance band of ±2%. India's retail inflation, based on the Consumer Price Index (CPI), the RBI's preferred gauge of inflation, was estimated at 4.38%.

"We are relatively in a better scenario compared to where we were in April and June. Although challenges remain in inflation and growth, policymakers and the Government of India is well positioned," Gaura Sengupta, chief economist at IDFC First Bank, said. "As long as crude remains above $80 per barrel and we see no signs of Iran-US ceasefire, challenges will continue."

Economists Back Status Quo on Rates

Against this backdrop, economists continue to favour the RBI's wait-and-watch approach, with the central bank expected to maintain the status quo for FY27, while some market participants expect a possible interest rate hike at the December policy meeting.

Economists argue that the RBI needs to adjust both its policy rate and its stance simultaneously, rather than relying on forward guidance alone. They say clear communication is especially important at a time when markets are highly sensitive to signals from central banks.

"Amid lack of guidance, including from the US Fed (US Federal Reserve), the financial markets are positioned such that they are picking up every noise from the market. This creates volatility and no central bank wants market volatility. Hence, RBI will have to be careful in the way they communicate their policy going forward," Pan said.

FCNR Inflows Support the Rupee

The RBI announced a slew of measures at the June policy meeting, including the launch of the Foreign Currency Non-Resident (FCNR) Bank account scheme and forex swaps to raise money abroad via external commercial borrowings for public sector units.

According to the latest RBI data, banks have received $40 billion via the FCNR(B) channel.

As per estimates by the State Bank of India and other market participants, the scheme is expected to bring in around $70 billion before it expires in September.

On the rupee front, economists expect near-term appreciation of the currency, supported by these inflows and intervention by the central bank in the domestic spot market.

However, rising geopolitical tensions and crude prices remaining relatively higher than pre-war levels continue to weigh significantly on the currency.

Global Central Banks Remain on Guard

Last week was eventful for financial markets. The Bank of Japan left its policy rate unchanged at 1% while signalling its willingness to hike rates if inflation risks persist.

The Bank of England also maintained the status quo, citing global uncertainties, though domestic inflation conditions remain benign. The European Central Bank also left its key policy rates unchanged after raising them by 25 basis points in June.

Could Fed Policy Shape RBI's Next Move?

The US Federal Open Market Committee (FOMC) kept the federal funds target range unchanged, though it signalled a preference for a 25 bps  hike.

US Federal Reserve Chair Kevin Warsh did not provide any forward guidance, indicating that policy decisions will be entirely based on upcoming economic data.

"It is a tricky and challenging environment for central banks and economists across the globe. It becomes a key question now if incase the Fed hikes rate in September, will the RBI's hands be tied given the narrowing interest rate differentials in UST (US Treasury yields)," Pan added.

In times of heightened global conflict and elevated oil prices, market sentiment heavily favours safe-haven assets.

Foreign investors are likely to choose risk-free US Treasury yields over emerging market debt, creating sustained capital outflow pressures and limiting the RBI's manoeuvring space in future monetary policy meetings.