RBI’s monetary policy meet: Not by a hammer alone

The Monetary Policy Committee (MPC) of the Reserve Bank of India begins its meeting today, with its decision due on October 7. The expectation is increasingly that the RBI may raise the repo rate by 25 basis points. The Federal Reserve of the US, the Bank of Japan and the European Central Bank have hiked rates recently.

The case for a hike is not difficult to make. Retail inflation rose to 4.82% in August from 4.45% in July, while food inflation touched 5.95%. At the same time, real GDP grew by a robust 7.8% in the first quarter of 2026-27. Credit growth is also strong: overall bank credit expanded by an unprecedented 19 % in August, while personal loans grew about 17%.

But should the answer necessarily be higher interest rates?
There is a school of thought that when inflation is primarily driven by supply-side factors—food, commodities or energy—monetary tightening can be a blunt instrument. If the price of crude oil rises because of geopolitical tensions, an interest-rate hike in India cannot make oil cheaper. Crude oil has trended to stay above $100 per barrel as the US-Iran faceoff has not been resolved yet. Also, if onions or potatoes become expensive because of supply disruptions or a lower yield, higher borrowing costs cannot produce more vegetables.

A structural feature which leaves monetary policy in India with limited bite is the extent of the informal sector of the economy which is assessed at about 40-45%. Crores of Indians live without being aware of the fact that there is an RBI or that there is a body like the MPC which believes that it has the power to influence price-rise and make daily necessities cheaper.

Yet monetary policy is not merely about directly influencing prices. Economics is an inexact science because it deals with behaviour, expectations and sentiment. A rate hike tells households, businesses and financial markets that the central bank is prepared to act against inflation. That signalling effect can influence consumption, investment and price-setting behaviour even before the full increase in borrowing costs is transmitted through the banking system. Further, economic agents who watch for monetary policy changes participate in the narrative about interest rates, include consumer goods manufacturers and wholesale traders.

Even for monetary transmission to take effect, there will always be a lag. Banks do not immediately reprice every loan and deposit when the repo rate changes. Consequently, the initial impact on inflation through tightening (rate hike) is likely to be modest. An interest rate hike also impacts growth. RBI research itself has found that a one-percentage-point increase in the policy rate can reduce inflation by about 22 basis points, while reducing GDP growth by around 30 basis points, with the effects occurring over several quarters.

That trade-off matters enormously for a developing economy, which is aspiring to grow its GDP in an effort to improve per capita income. The total fertility rate at the national level being below 2 augurs well for this target. If India can maintain steady growth, it will necessarily lead to higher incomes, better standards of living and take it closer to an upper middle income country. India could become a China of today, about 20 years later, purely in terms of per capita income. Of course, we do not ever want to be a single-party dictatorship polity like China.

India should therefore be cautious about relying exclusively on interest rates to fight inflation. The revised CPI gives food a substantial weight (though lower than earlier), and food and energy shocks can dominate headline inflation. Monetary policy cannot solve these supply-side problems. Indeed, higher rates can sometimes compound the pain by raising financing costs for producers and consumers.

There is another issue that deserves attention: the composition of credit. Personal loans grew 17% in August, while credit to industry rose 18 % and services 24 %. Gold-loan growth was still a striking 83.2%. These numbers suggest that the RBI needs to keep a close watch on pockets of overheating rather than simply suppressing demand across the economy. This is where macro-prudential tools can be useful. Instead of using the same instrument for every problem, the RBI can employ additional risk weights, capital requirements and other regulatory measures to restrain excessive credit in particular sectors while allowing productive investment to continue. For this objective, higher interest rate is not the apt instrument.

I remember Dr YV Reddy, legendary RBI Governor, once making an inimitable point during an informal conversation, that has stayed with me. We are, he said in effect, middle-class people. We do not want too much of anything—not spectacular highs, nor devastating lows. We want stability. The same principle, he suggested, applies to economic growth. A sustainable growth rate of around 7% in real terms is preferable to a boom followed by a collapse.

That is perhaps the balance the MPC must seek now. It needs to be aware that relying on the interest rate alone may not quite be the solution now. Let us remember that the MPC had failed in meeting its target for three consecutive quarters earlier in 2022-23. The lack of transparency surrounding a report/letter sent to the Union Government by RBI about this, actually clouds the issue.

There is also a fiscal dimension to higher interest rates. Higher rates eventually raise the cost of borrowing not only for households and companies but also for governments. The 10-year benchmark government security yield has recently crossed 7.1%, adding to borrowing costs of both the Union and State governments.

So what will the MPC do today till Wednesday?
A 25-basis-point hike is increasingly being priced into expectations. But the more important question is whether it would be a one-off adjustment or the beginning of a tightening cycle. Markets will watch the language of the MPC as closely as the rate itself.

The RBI has other instruments at its disposal—liquidity management (changes in CRR), targeted regulatory measures using credit risk weights and open market operations in government securities (given the mountain of liquidity from the FCNR deposit scheme with guaranteed forward cover) . The challenge is to use them intelligently rather than treating the repo rate as the only answer to every inflationary problem.

After all, if you think all you have is a hammer, every problem begins to look like a nail. Sometimes the interest rate is precisely that—a blunt tool. The MPC should not delude itself into believing that all it has is a hammer. It has a wider tool-kit if only it were to look deeper.

For the MPC, the task is not simply to tame inflation; it is to do so without unnecessarily sacrificing growth. That makes today’s meeting one of the most consequential in recent times. The MPC members have a huge responsibility on their shoulders.