Context

• India’s monetary policy is approaching a delicate phase as the real policy rate is losing its cushion despite strong economic growth.
• The Reserve Bank of India (RBI) has retained the repo rate at 5.25%, while consumer inflation has risen for three consecutive months to 4.82% in August.
• Food inflation stands at 5.95%, while core inflation has risen to around 4.2%. These developments raise concerns about whether monetary policy remains sufficiently restrictive.
• The crucial issue is not merely the difference between the repo rate and past inflation. Monetary policy also operates through inflation expectations.
• If expected inflation approaches 5.25%, the ex-ante real policy rate could approach zero, weakening monetary restraint.

The Erosion of the Real Policy Rate

• The RBI has retained a neutral monetary policy stance while projecting FY2026–27 inflations at around 5%.
• However, inflation at 4.82% is already approaching the policy rate.
• A positive real interest rate normally discourages excessive borrowing and encourages saving.
• As inflation expectations rise, this restraint diminishes. India could therefore enter a near-zero real interest-rate environment if inflation continues to accelerate.
• This is particularly important because economic activity remains strong rather than demand-deficient.

External Inflationary Pressures

• West Asian conflict and disruptions around the Strait of Hormuz have raised concerns over energy supplies, while Brent crude has moved above $100 a barrel and approached $110.
• Higher crude prices can increase transportation and production costs, widen the import bill and weaken the rupee.
• Consequently, higher oil prices and a weaker rupee can intensify imported inflation.
• The monsoon also remains an important uncertainty because food prices significantly influence headline inflation.
• Persistent supply shocks could eventually affect inflation expectations, wages and pricing behaviour.

Strong Credit Growth and Banking-System Dynamics

• Bank credit grew 19.1% year-on-year at the end of August, indicating strong demand for loans. GDP growth of 7.8% further demonstrates economic resilience.
• Deposit growth reached 17.8%, reportedly its fastest pace in a decade.
• However, this figure requires careful interpretation because the RBI’s special FCNR(B) mobilisation scheme contributed to foreign-currency inflows.
• It therefore does not necessarily indicate a comparable rise in conventional domestic household deposits.
• The credit-deposit ratio was around 80.3%, highlighting the need for banks to balance strong lending demand with stable funding.

Inflation and Household Financial Behaviour

• When inflation exceeds deposit returns, the real return on conventional bank deposits declines, encouraging savers to consider equities, mutual funds, gold and other assets.
• RBI research on the 2010–2013 high-inflation period found that real returns on savings instruments became negative, financial savings weakened and gold demand increased.
• The study estimated a 0.83 correlation between gold imports and household inflation expectations.
• Persistent inflation can therefore affect not only consumption and investment but also the composition of household savings and bank deposits.

Should Monetary Policy Have Tightened Earlier?

• Whether the RBI should have acted earlier involves a difficult trade-off.
• A central bank should not automatically raise interest rates after every oil-price shock, particularly when inflation originates from supply disruptions.
• However, risks increase when temporary shocks begin influencing inflation expectations, wages, prices and credit demand.
• Current conditions warrant vigilance: inflation has remained above 4% for three consecutive months, core inflation is around 4.2%, and the one-year overnight index swap (OIS) rate near 6% signals expectations of future tightening.
• At the same time, strong GDP growth and rapid credit expansion indicate that domestic demand remains resilient.

The Importance of Timing

• The central issue is increasingly one of monetary-policy timing.
• Delaying action when inflation becomes persistent can eventually require stronger intervention if expectations become entrenched.
• A 25-basis-point adjustment could provide a gradual response if conditions warrant it, whereas prolonged inaction could necessitate a larger correction later.
• The appropriate decision, however, depends on inflation persistence, expectations, oil prices, exchange-rate movements and domestic demand.

Conclusion

• India faces a challenging monetary-policy environment in which inflation is approaching the repo rate while growth and credit remain strong.
• Rising food and core inflation, external oil-price risks, currency pressures and rapid credit growth could progressively reduce the effectiveness of the existing real policy rate.
• The RBI’s challenge is to distinguish temporary supply shocks from persistent inflation while maintaining economic momentum.
• Price stability requires careful calibration rather than automatic tightening.
• As the real interest-rate cushion diminishes, timely and measured monetary-policy action becomes increasingly important.