Real Policy Rate Nears Zero as August CPI Inflation Hits 4.82% With Repo at 5.25%

The news

New Delhi. With the Reserve Bank of India holding its repo rate — the rate at which it lends overnight to banks — at 5.25%, Consumer Price Index inflation rose to 4.82% in August from 4.45% in July, the third consecutive month above the RBI’s 4% target, writes Saumitra Bhaduri, Professor at the Madras School of Economics, in The Hindu. Food inflation is higher at 5.95%, and core inflation — inflation excluding the volatile food and fuel items — has risen to around 4.2%, suggesting that price pressures are broadening. The real policy rate is the policy rate minus expected inflation; the author argues that if the repo stays at 5.25% while inflation expectations move towards 5.25%, the ex-ante (forward-looking) real rate becomes approximately zero. At its August policy, the RBI kept a neutral stance — signalling neither an easing nor a tightening bias — and projected FY2026-27 inflation at around 5%. The risks cited are the monsoon and an external shock: renewed conflict in West Asia has disrupted shipping through the Strait of Hormuz and pushed Brent crude above $100 a barrel, approaching $110, while the rupee has weakened. Demand is strong: GDP growth is running at 7.8% and bank credit grew 19.1% year-on-year at the end of August. Deposits grew 17.8%, the fastest in a decade, but partly because of the RBI’s special FCNR(B) scheme — foreign currency deposits of non-resident Indians — and the credit-deposit ratio was around 80.3%. The Economic Times reports that banks mobilised $127.22 billion through FCNR(B) deposits in less than three months until the dollar mop-up closed on August 31, with ICICI Bank at $17.88 billion and HSBC at $14.5 billion. The author cites RBI research on 2010-2013, when real returns on savings turned negative, household financial savings weakened and gold demand rose, with a correlation of 0.83 between gold imports and household inflation expectations. The one-year overnight indexed swap rate — a market contract whose price reveals expected short-term rates — is around 6%, signalling expected tightening. His conclusion: “A timely 25-basis-point adjustment may ultimately cost less than a delayed 50-basis-point correction” (one basis point is one-hundredth of a percentage point). The syllabus link is monetary policy, inflation and the mobilisation of household savings — capital as a factor of production.

Static syllabus linkage

1. Inflation targeting is a statutory mandate, not a policy preference. The Finance Act, 2016 amended the RBI Act, 1934 to insert Section 45ZA, under which the Central Government, in consultation with the RBI, sets the inflation target once every five years. The target notified in 2016 is 4% CPI inflation with a tolerance band of 2% to 6%. Under Section 45ZN, the RBI is deemed to have failed if average inflation stays above the upper or below the lower tolerance level for three consecutive quarters, and it must then report to the Centre the reasons and the remedial action proposed.
2. The Monetary Policy Committee has six members and the Governor holds the casting vote. Section 45ZB of the RBI Act provides for a six-member Monetary Policy Committee: the Governor as chairperson, the Deputy Governor in charge of monetary policy, one RBI officer nominated by the Central Board, and three members appointed by the Central Government for four years who are not eligible for reappointment. The quorum is four, decisions are by majority, and in case of a tie the Governor has a second or casting vote. The committee must meet at least four times a year, and the minutes are published.
3. Real interest rate is the price of money after inflation. The nominal rate is the rate written on a loan or deposit; the real rate is the nominal rate minus inflation. The ex-post real rate uses inflation that has already happened, while the ex-ante real rate uses expected inflation, and it is the ex-ante rate that shapes decisions to save, borrow and invest. A positive real rate rewards saving and restrains borrowing; a zero or negative real rate does the opposite, which is why central banks watch it rather than the nominal rate alone.
4. FCNR(B) deposits put the exchange risk on the bank. Foreign Currency Non-Resident (Bank) deposits are term deposits held by non-resident Indians in foreign currency with banks in India, for maturities of one to five years, and both principal and interest are repaid in that foreign currency. The exchange-rate risk is borne by the bank, which is why the RBI’s offer of a concessional swap window — under which banks convert dollars into rupees at a set cost — makes mobilisation attractive. India used this route in 2013 to stabilise the rupee after the taper tantrum, when about $34 billion was raised.

Why UPSC loves this

1. Monetary policy and inflation are standing GS3 topics. The syllabus names “Indian Economy and issues relating to planning, mobilisation of resources, growth, development and employment”. Questions on the flexible inflation targeting framework, the MPC and transmission recur, and Prelims regularly tests instruments such as repo, reverse repo, the standing deposit facility and the cash reserve ratio.
2. Supply shocks test the logic of inflation targeting. The examiner likes the question of whether a central bank should respond to an oil shock it cannot control. This story gives the textbook answer — look through temporary supply shocks — and the case against it when demand is strong and core inflation is rising.
3. Household savings link monetary policy to capital formation. The shift of household savings from bank deposits to gold, mutual funds and equities is directly relevant to questions on financial inclusion, the financialisation of savings and the funding of investment.

Analysis

1. The market has already tightened even though the RBI has not. A one-year overnight indexed swap rate of around 6%, against a repo of 5.25%, means the money market expects rates to rise and is already pricing loans and bonds accordingly. In that sense part of the tightening the author asks for is already in effect through market rates. The counter-argument cuts the other way: if the RBI fails to confirm what markets expect, it signals tolerance for higher inflation, and expectations — the variable that determines the ex-ante real rate — can drift upward. Central bank credibility is measured by whether markets’ expectations are validated, not by the level of the repo alone.
2. Looking through an oil shock is right only when demand is weak. The standard doctrine says a central bank should ignore a supply shock such as higher crude prices, because rate hikes do not produce oil and only add a growth loss to a price shock. That doctrine assumes the shock stays confined to fuel. With GDP growing at 7.8%, credit at 19.1% and core inflation rising to 4.2%, the conditions for second-round effects — wages and prices of other goods adjusting to fuel costs — are present. The honest counter-view is that 4.82% is still inside the 2-6% band, which was designed precisely to absorb supply shocks without a reflexive rate response.
3. The deposit surge is largely borrowed confidence, not domestic saving. Deposit growth of 17.8% looks like strong savings, but $127.22 billion of FCNR(B) inflows mobilised in under three months accounts for much of it. That money is foreign currency, swapped into rupees at a cost, and the HSBC example of leverage of up to 19 times shows that much of it was borrowed money chasing yield rather than fresh saving. Domestic households, facing near-zero real returns on deposits, are moving to mutual funds, equities and gold. For capital formation this matters: gold is an unproductive asset for the economy, and the 2010-13 episode, with its 0.83 correlation between gold imports and inflation expectations, ended in a current account crisis.
4. A zero real rate quietly transfers income from savers to borrowers. Borrowers with loans linked to external benchmarks such as the repo rate see their costs fixed in nominal terms while inflation erodes the real value of their debt. Savers holding fixed deposits — often pensioners and households without market access — receive returns that barely keep pace with prices. The decision to hold rates steady is therefore not neutral in its distributional effects, even if the stance is called neutral. An answer that notices this links monetary policy to the GS2 concern with vulnerable sections.
5. Timing is an instrument, but so is patience. The author’s best point is that a small early move preserves credibility and may prevent a larger later one. The case for waiting is that the West Asia shock could reverse as quickly as it arrived, and the monsoon outcome is not yet known; a hike that coincides with a supply-driven slowdown would hurt growth without reducing oil prices. The MPC’s decision will turn on whether it reads rising core inflation as the beginning of a broad-based trend or as a pass-through that will fade. That judgment, not the formula, is where monetary policy is actually made.

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