The Reserve Bank of India's Monetary Policy Committee Wednesday raised the repo rate by 25 basis points to 6.50%, the highest level in the past four years, in an attempt to cool off inflation.

The MPC has raised the repo rate in every meeting since the off-cycle meeting of May 2022, taking the policy-setting rate higher by 250 basis points. The MPC's decision will force the banks to raise deposit and lending rates in the coming weeks.

Here are the main decisions of the MPC and some interpretations:

Divided House:The MPC voted to raise the repo rate to 6.50 percent with a 4-2 vote, meaning two of the six members dissented and did not want the committee to raise interest rates. The voting pattern shows the dissent has grown. In December, only one member had dissented against raising interest rates.

Not Done Yet:There was no change in the stance of the monetary policy as was expected by the markets. The RBI retained its stance that read MPC "to remain focused on the withdrawal of accommodation."

The same two members dissented on this aspect too. The MPC sticking to its stance means that it could raise interest rates even more. Some analysts who expected RBI to start cutting rates this year will have to rethink that assessment.

The MPC will probably pause its rate hikes in April before changing its stance to neutral. Once RBI terms its stance neutral, it will have to put rate cuts on the table.At this point of time, the RBI wants to be prepared given the high core inflation, US Federal Reserve's interest rate moves, and geopolitical uncertainties. The "situation remains fluid and uncertain", the RBI said.

Aggressive On Growth, Conservative On Inflation:The RBI's projections both for growth and inflation are at variance with what economists have estimated, mostly overshooting the market expectation.

The RBI has likely kept some buffer for inflation by being conservative on the extent to which inflation will fall next financial year. More often than not, RBI's growth projections have an upward bias as such projections tend to have their own signaling impact on industries and markets.

The key takeaway from a future policy perspective is that RBI's inflation projections are all above 5% for the next four quarters, and its main target is 4%. It is not that RBI will keep raising interest rates till inflation reaches 4 percent but it is unlikely to resort to rate cuts till it is sure inflation of 4% will show up in its forecast models.

Sticky Core:The main bugbear for the MPC is the core inflation, which is the headline inflation rate minus volatile elements like oil and food.

Core inflation has been around 6% for many months and has been sticky (since July 2020).

In some sense, more than the headline inflation number, it is the core inflation that MPC is giving more attention to. While the headline number has come down (5.7% in December) from the recent highs (7.8% for April 2022), core inflation has not shown any signs of ebbing. The RBI considers the core to be the underlying inflation.

The MPC will wait for core inflation to ease before it changes its stance explicitly. For now, it is waiting for its past monetary policy hikes to break the persistence of core inflation.

Low Real-Repo:The RBI is not perturbed by calls that it has already raised interest rates too much or has tightened too much.

RBI Governor Shaktikanta Das has said that adjusted for inflation; the policy repo rate still trails its pre-pandemic levels. The real repo rate is +90 basis points if one considers the year-ahead inflation rate.

Some academic papers from RBI have said recently that the neutral rate of interest (or the real rates) should be around 90-100 basis points for India. There is no hard rule. The neutral rate is a function of the RBI's macroeconomic objectives at that point in time. Given its fight against core inflation, the neutral rate could well above 1 percentage point.

Moreover, liquidity remains in surplus, with an average daily absorption of ₹1.6 trillion under the LAF in January 2023. The RBI would want it to turn neutral before it take a position on its overall stance.

What's Next?

The RBI's action is expected to nudge banks to raise their deposit and lending rates. A significant chunk of liquidity is set to leave the banking system with the expiry of LTRO, a mechanism instituted during the pandemic.

At this point of time, the RBI has only said that it will conduct fine-tuning operations with regard to liquidity and did not commit to adding to durable liquidity. Banks are planning to cut down on their holdings of excess bond reserves to meet credit requirements. But that may not be enough, banks will have to raise deposits to meet their core liquidity needs.

Currently, credit growth at 16.5% year on year is fast outstripping the pace of growth in deposits that is at 10.6%.

Apart from meeting credit requirements, banks need to raise rates to also preserve their depositors, who now have attractive options in the form of better returns from small savings schemes of the central government.

The latest Budget announced Mahila Samman Savings Certificate from this year, offering 7.5% per annum on 2-year deposits. Banks will have to raise deposit rates to prevent funds from moving from them to the new scheme of government.

As for the RBI, it will most likely pause rate hikes in April but retain the stance on the withdrawal of accommodation to keep its options open. The RBI will keep the suspense going.

Repo rate may have peaked for now. The pressures on current account deficit and inflation that stemmed from the commodity shocks may have now passed. Once the LTRO mechanism matures, liquidity will enter a neutral zone, allowing the RBI to take a fresh look at its stance.

The RBI will keep an eye on the Fed and how the exchange rate behaves in the next few months before decisively changing the stance to neutral or signal cuts in interest rates.

For now, a 'high (if not higher) for longer rate' stance can be expected back home as well. Depositors can expect to benefit.