RBI may have to tighten more as global rates shift higher

The Reserve Bank of India could be at the beginning of a more prolonged rate-tightening cycle, with the October 7 monetary policy meeting potentially marking the first step. Harshal Joshi, Senior Vice President – Fixed Income at Bandhan AMC, expects the RBI to raise the repo rate by 25 basis points to 5.50%, following August CPI inflation of 4.82%.

More importantly, Joshi expects the tightening to extend well beyond the upcoming policy. His base case is for at least three to four rate hikes over the next few policy meetings, amounting to a cumulative increase of 75-100 basis points.

The argument is increasingly global. The neutral real rate, or the level of interest rates consistent with an economy operating without excessive inflationary or deflationary pressure, has moved higher globally. Strong US growth, a more hawkish Federal Reserve, and a firmer dollar are all contributing to a higher global rate environment.

For India, this creates a capital-allocation challenge. Indian assets compete with global markets for foreign capital, and a combination of higher US yields and a stronger dollar can increase the pressure on domestic rates. If global commodity prices and real-rate pressures remain elevated, Joshi believes the RBI could require “considerable tightening” in the months ahead.

Yet the domestic money market presents a curious counterpoint. Liquidity remains highly accommodative despite the RBI’s efforts to absorb excess funds. System liquidity is currently estimated at around ₹5.4-5.5 lakh crore, although that is substantially below the peak of more than ₹10 lakh crore seen during the FCNR(B) conversion phase.

The RBI has already used several instruments to drain liquidity, including variable rate reverse repo operations, foreign exchange swaps, and ₹1 lakh crore of open market bond sales in September. Even so, overnight rates remain below the repo rate. TREPS, for instance, averaged around 5.10% last week, compared with the 5.25% repo rate.

Government cash balances accumulated from advance tax collections are also expected to reverse as government spending picks up in early October. That could keep overnight rates relatively soft around the October policy.

This makes liquidity management almost as important as the repo rate itself. The RBI has indicated that it can use bond sales and foreign exchange swaps to bring overnight rates closer to the policy rate, suggesting that further liquidity operations could play a crucial role in determining how effectively monetary tightening is transmitted through the financial system.

The bond and money-market curves are already reflecting some of these expectations. Certificate of Deposit rates have moved higher at the front end over the past week, while the curve remains relatively steep through March. With credit demand typically strengthening during the third and fourth quarters of the financial year, CD supply could increase in the coming months.

Against this backdrop, Bandhan AMC remains firmly defensive on duration. Joshi says the 3-5 month segment remains the core positioning for its money market schemes, offering carry and roll-down while limiting exposure if rates rise faster than anticipated.

For investors, the message is similarly conservative. The next few RBI policies could determine how far and how quickly rates move. In such an environment, shorter-maturity strategies offer an important advantage: the ability to reinvest at higher rates as the tightening cycle develops.