ExplainSpeaking: How RBI decides to do, or not do, anything in its monetary policy review

Once every two months, the RBI’s MPC sits down to take stock of India’s economy and decide whether it wants to change the interest rates prevailing in the country.

Most economists and observers expect the RBI to “maintain a status quo” on interest rates. The lack of any changes in the interest rates, however, should not detract from the fact that the world over economies are facing a fairly unprecedented level of uncertainty. Even when a central bank decides to do nothing, as it were, it bases its decision after considering several factors.

What’s the point of RBI monetary policy reviews? 

Like all central banks, the RBI too is charged with the responsibility of maintaining stable prices in the Indian economy.

It does this by targeting the retail inflation rate — that is, the rate at which the general price level experienced by Indian consumers increases from one year to another — at 4%. 

The RBI’s research has shown that this is the ideal rate of inflation that promotes sustained economic growth. If the inflation rate remains persistently higher than 4%, it erodes purchasing power of consumers in the economy. If it stays persistently below 4%, it weakens the profit incentive of producers.

The main tool with which the RBI tries to achieve this goal of 4% inflation is by tweaking the interest rate it charges when it lends money to India’s commercial banks to meet their short-term needs. This interest rate is called the “repo rate”.

When the RBI evaluates that economic growth is weak and inflation rate is falling below its target, it reduces the repo rate — making it cheaper for commercial banks to borrow. When the cost of their own borrowing falls, commercial banks cut the interest rate at which they lend to the rest of the economy — be it a consumer wanting to borrow for purchasing a car or home or a businesswoman wanting to borrow to start her own company. This is how the RBI incentivises economic growth while maintaining price stability.

When the RBI sees inflation rate going up too high — either because there is too much demand for goods and services in the economy or because there is too little supply — it raises the repo rate to dampen demand. A repo rate increase triggers banks to raise interest rates for all kinds of consumers, thus forcing many to give up their demand for a new car or a new company.

What are the factors the RBI has to consider?

In any meeting, the RBI has three choices: hike interest rates, cut interest rates, or maintain status quo.

On the face of it, the RBI targets the retail inflation rate. That, of course, is the main variable on which it bases its decision.

Chart 1: India’s inflation rates in the past two years.

Chart 1 shows that retail inflation has risen through 2026 and is now just above the 4% target, even though it is still within the RBI comfort zone of 2% to 6%. Chart 2 shows the movement of the repo rate over the same period.

Chart 2: Changes in repo rate in the past two years.

However, looking at just the headline inflation number is not enough.

As things stand at present, one can argue for a rate cut: after all, inflation is close to the target level and well within the comfort zone even as economic growth is expected to slow down. Or, for a rate hike, since inflation is steadily rising up over the past few months.

But since the RBI’s monetary policy action — the tweaking in repo rate — takes a while (often several months) to percolate through the economy, the RBI, or any central bank for that matter, has to consider many other factors beyond just looking at the headline inflation number.

In many ways, the RBI has to continuously assess not just where India’s growth and inflation are at present but also, and even more importantly, where they will be in a few months’ time.

Here is a list of some of the other key factors that RBI is likely to take into account in its deliberations.

1) Crude oil prices: As explained in another recent explainer, higher crude oil prices don’t just raise domestic inflation but also worsen India’s trade deficit, hit rupee’s exchange rate, increase government debt, and bring down economic growth. 

Thanks to the inconsistent nature of the ceasefire between the US and Iran, crude oil prices continue to swing wildly from one week to another. 

But crucially, since the middle of June when the peace deal was signed, crude oil prices have gone up by around 11%. 

If the RBI expects crude oil prices to remain high or possibly even go higher, it may consider raising rates or, at the very least, keep interest rates higher for longer.

2) Hostilities between the US and Iran: The same argument applies here as well. If the war continues, supply of energy will remain constrained and prices will continue to remain elevated. This is more so because apart from the Strait of Hormuz, now even shipping through the Red Sea has come under threat. 

Such an assessment will likely singe any plans within the RBI to cut interest rates.

3) Monsoon, El Niño and outlook on domestic inflation: Regardless of what happens to crude oil prices, there is another big threat to domestic inflation in the form of El Niño. 

As per the India Meteorological Department, El Niño conditions are likely to intensify in the coming months.

As of end-July, rainfall is 13% below average and more than 40% of area in the country remains in the deficient category. Water reservoir levels are considerably lower than what they were at the same stage last year. These can adversely affect the rabi sowing.

Food inflation was already well above 5% in June and these developments may tilt the RBI towards either raising rates or keeping them at the same level.  

4) Quality of India’s growth momentum: All central banks have to balance between controlling inflation and promoting economic growth. Further, while deciding on its interest rate policy, the RBI concerns itself not just with the level of economic growth but also assesses the quality of growth momentum. It is entirely possible that the growth rate in the past year or the last quarter was strong enough but there are emerging signs of weakness. 

To assess this, the RBI goes beyond the GDP growth rate of the past year or the last quarter, and looks at the picture painted by a whole host of high frequency indicators. 

For instance, as a recent report from Bank of Baroda notes, “high frequency data for quarter ending June 2026 indicates that airline passenger traffic (including domestic travel), rail freight traffic, diesel consumption, GST e-way bill generation growth, all slowed compared with June 2025”. On the other hand, “port cargo traffic, telecom subscribers, vehicle registrations and GST collections have maintained upward momentum” in the same quarter (April, May and June).

Clearly, the high frequency indicators are painting a mixed picture of the economy. Each of these components mentioned above will show in different components of the GDP calculation in the future. For instance, a slowdown in airline passenger traffic and rail freight will get counted in the services component of the GDP, while the boost to port cargo will come under the external sector of GDP.

A mixed picture suggests that the underlying growth momentum is uneven — that is, it is not the case that every sector is looking up. This, in turn, has a key policy implication: The RBI will have to be cautious about raising interest rates. 

If all sectors were doing well, the RBI could be tempted to raise rates in the hope that the underlying growth momentum is robust enough to take an interest rate hike in its stride. But if growth is not broad-based, a rate hike can also hurt several sectors that were in any case not doing as well.

5) Action of other central banks, especially the US Fed: Typically, interest rates in India are higher than the interest rates in the developed countries such as the US and euro area because the inflation rate is also higher. This gap between the two interest rates often plays a big role in attracting global investors to invest in India via the bond market (a market when money is lent and borrowed), thus providing money that is borrowed by Indian companies as well as the government.

As such, if other central banks raise interest rates, there is pressure on the RBI to raise rates and protect India’s attractiveness as an investment destination for debt funds. 

But there is a flip side too.

Higher interest rates also raise the cost of borrowing for everyone in the economy, especially the government. An increase in interest rates can hurt the government’s debt calculations.

As of their last meetings in July, the Federal Reserve (of the US), the European Central Bank (of the Euro area), the Bank of Japan, and the Bank of England all maintained status quo on the interest rates prevailing in their respective economies. 

This brings down the pressure on the RBI to hike rates. 

Conclusion

This is not an exhaustive list of factors that the RBI will cover but it provides a glimpse of the numerous considerations that policymakers at the MPC have to make before they arrive at any decision — even one where they decide not to do anything. 

Should the RBI cut rates or raise them or just stay watchful for now? Share your views and queries at udit.misra@expressindia.com

Take care,

Udit