Why has RBI kept interest rates unchanged despite mounting inflation risks?

The Reserve Bank of India’s Monetary Policy Committee (MPC) Friday kept interest rates unchanged at 5.25% despite mounting inflationary pressures from spiralling crude oil prices and shortages caused by the West Asia conflict.

Interest rates on home, vehicle, corporate and personal loans in the banking system are expected to remain steady following the MPC decision.

With risks from elevated oil prices, uncertainty in global trade, adverse weather conditions and geopolitical tensions clouding the economic outlook, the RBI policy panel has lowered the growth projection for this financial year from 6.9% to 6.6% and hiked the inflation forecast from 4.6% to 5.1%.

The tensions in West Asia involving the US, Israel and Iran threaten to keep energy costs high, disrupt global supply chains and trigger volatility in financial markets. This comes at a time when India is seeing sustained capital outflows, and the rupee and forex reserves are facing pressure.

When a central bank wants to boost economic activity, it makes it cheaper for people to borrow money by reducing interest rates. When it wants to rein in inflation, it makes borrowing more costly by increasing the interest rates.

RBI policymakers chose to take a cautious approach, keeping their main policy policy instrument, the repo rate, unchanged. The repo rate is the interest rate at which the central bank lends to commercial banks.

When the central bank maintains the current rate, it generally means that lending rates offered by banks and financial institutions are unlikely to rise in the near term. As a result, equated monthly instalments (EMIs) on loans — homes, vehicles, personal needs, corporate financing or small businesses — are expected to remain stable. Deposit rates are also expected to remain unchanged for the time being.

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This will come as a significant relief for borrowers across various segments of the economy.

The RBI is expected to watch the emerging economic conditions before making further adjustments, ensuring that both borrowers and lenders operate in a relatively stable interest rate environment.

A pause in interest rates is generally viewed as a “wait-and-see” stance by policymakers. Economic growth is expected to continue at its current trajectory, though the economy does not benefit from the additional stimulus that a rate cut would provide. At the same time, stable borrowing costs offer businesses a predictable financing environment, helping them plan investments with greater confidence.

Growth forecast slashed

As expected, the MPC lowered growth projections from its earlier projection of 6.9% to 6.6%.

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The RBI’s Annual Report said the West Asia conflict and risks such as higher energy prices, supply chain disruptions, financial market volatility, global trade uncertainty and weather disruptions could affect growth and inflation in the short term. In a highly uncertain global environment, continuous assessment of the evolving developments is warranted to frame the appropriate policy response on an ongoing basis, the central bank said.

With this, the growth forecast is now down by 100 basis points as the MPC forecast a lower growth of 6.9% for FY27 in April as against 7.6% projected earlier.

Unveiling the policy, RBI Governor Sanjay Malhotra said the committee noted that the global environment has deteriorated since the last policy meeting, in April, with a conflict lingering amid a fragile truce. “There are those implications of the extended disruption in supply chains, and elevated energy prices are reflected in the moderation of growth, and increase in inflation,” Malhotra said.

“The MPC noted that elevated energy prices, coupled with global supply constraints, are having adverse spillovers for economic activity. While domestic demand remains resilient, and manufacturing and services, sectors, activities, continued to expand,” Malhotra said.

Inflation forecast hiked

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The RBI has revised its inflation projection upward in line with the projection. CPI inflation in FY27 has been hiked to 5.1% from 4.6% projected in the April review as inflationary pressures in the economy continue amid the geopolitical uncertainties.

The cumulative increase in retail fuel prices following the conflict in West Asia is estimated to have a direct impact of around 35 bps on headline CPI inflation which was at 3.48 per cent in April. Indirect inflationary pressures may add another 10–15 basis points to overall CPI inflation. High WPI inflation in April to 8.3% increases the risk of faster pass-through to consumers.

The MPC faced a difficult policy environment as the situation in West Asia remains volatile, with uncertainty persisting over the durability of the ceasefire. Despite the recent increase in retail fuel prices by Rs 7.5 per litre, there remains further scope for upward revisions, depending on the trajectory of global crude oil prices

The inflation rationale has also gained credibility amid successive pump price increases, a pickup in food, impact of prevailing heatwave conditions and rising business inflation expectations, all of which point to mounting underlying price pressures.

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With the MPC forecasting a higher retail inflation of 5.1%, the projection has gone above the RBI’s 4 per cent medium-term target.

Future trajectory of the policy rate will depend on the MPC’s assessment of evolving inflation dynamics, which are significantly influenced by external factors. If conflict persists and inflation risks become entrenched in household expectations, rate hikes could be considered toward the end of the year, analysts said.