Reserve Bank of India surprises all by keeping interest rates unchanged

• Contrary to market expectations, the monetary policy committee of the RBI kept the repo rate unchanged at 6.5%.
  
• Given the falling rupee and higher fuel prices, It was widely expected that the central bank would hike the repo rate to 6.75% to keep inflation in check.
  
• In anticipation of a rate hike, banks like SBI and HDFC increased borrowing rates while fund managers increased their cash holdings.
  

After two consecutive rate hikes of 25 basis points, the monetary policy committee of the Reserve Bank of India (RBI) surprised market pundits by keeping the repo rate on hold at its meeting on 5 October. This is the rate at which it lends money to domestic banks.

Given the falling rupee and higher fuel prices, it was widely expected that the central bank would hike the repo rate from 6.5% to 6.75% to keep inflation in check. This would have marked the strongest tightening cycle since 2013. In anticipation of a rate hike, banks like SBI and HDFC increased borrowing rates while fund managers increased their cash holdings.

The monetary policy committee probably decided against the rate hike for two reasons. Firstly, it ascertained that inflation was in a manageable range given the recent decline in food prices. Secondly, three consecutive rate hikes would have significantly dampened demand for loans, translating to a slowdown in investment and economic activity.

However, there will likely be further rate increases ahead. The RBI did change its stance from “neutral” to hawkish, explaining that it would focus on the “calibrated tightening of monetary policy” in order to ensure headline inflation did not exceed its 4% target by more than 2%. As things stand, inflation is expected to touch 4.5% by the end of the current fiscal year.

Despite internal and external pressures on the Indian economy, the central bank retained its growth forecast of 7.4% for 2018-19 and 7.6% for 2019-20.

Rupee goes past 74

The market did not react well to the RBI’s decision. The rupee, which was trading at 73.81 to the US dollar by the end of 4 October, crashed below 74. The rupee has been in freefall in the year so far owing to capital outflows as foreign investors rerouted funds from emerging markets like India to safe havens like the US, where the Federal Reserve is tightening rates.

Meanwhile, the Sensex, an index of 30 strong companies on the Bombay Stock Exchange, has fallen by nearly 800 points following the RBI’s announcement. The repo rate hike would have made interest rates more attractive for foreign investors, which would have helped in the accumulation of capital inflows.