The Reserve Bank of India's Monetary Policy Committee Thursday left the repo rate unchanged for the first time since it began raising the rate in May 2022 and could now switch from rates to the liquidity channel in its continued attempts to cool inflation.

Consequently, banks' lending rates may hold steady in the coming months, but tighter liquidity could drive up deposit rates.

The MPC's decision surprised the markets, which had priced in a 25-basis-point hike as a safe bet after the US Federal Reserve raised the rate by 25 basis points on March 22 to 4.75-5.00% despite signs of stress in US banks.

The market was also surprised because the pause came despite the CPI inflation remaining above the upper bound of the MPC's 2-6% target in January and February.

Since the RBI was unmoved even after the surprise inflation prints, the bar for resuming rate hikes will be very high.

Hawkish Pause

The MPC left the repo rate unchanged at 6.50% Thursday via a unanimous vote. The rate has been raised by 250 basis points since May 2022.

The MPC also left the stance unchanged, which continued to read "withdrawal of accommodation" via a 5:1 vote. An external member of the Committee, J.R. Varma, dissented as he has been doing for a few rounds of meetings now. The stance indicates that the RBI can raise the repo rate again.

RBI Governor Shaktikanta Das issued these warnings today to buttress the point that RBI's rate hiking cycle is not over:

Today's monetary policy "is a pause, not a pivot" (to cut rates). Decision to "pause on the repo rate is for this meeting only. MPC will not hesitate to take further action in its future meetings.

The MPC took a breather a year after it started raising interest rates in April last year with the introduction of the Standing Deposit Facility to shift the floor of the rate corridor to 3.75% from 3.35% as set by the then prevailing reverse repo rate.

Considering that, the interest rates have since risen 315 basis points from the reverse repo rate of 3.35% to the repo rate of 6.50% now. The weighted average call rate rose 290 basis points to 6.52% from 3.32% in March 2022.

The MPC wanted to assess the cumulative impact of these rate hikes. Moreover, a significant chunk of liquidity is set to leave the banking system with the expiry of TLTRO, a repo mechanism instituted during the COVID pandemic. The RBI can also assess how tighter liquidity exerts pressure on demand conditions in the economy.

Some ₹447 billion of TLTROs will mature this month. Since March, ₹299 billion of LTROs had already matured.

The RBI marginally raised its forecast for 2023-24 GDP growth to 6.5% from 6.4% made earlier (versus 7.0% estimated for 2022-23). It cut its inflation forecast to 5.2% from 5.3% for the year.

This, too, may have helped the MPC pause. It helps, directionally, when the central bank forecasts a higher-than-previously-projected growth and a lower-than-previously-projected inflation.

The MPC may also have been comforted by the fact that despite Fed's rate hikes, the rupee has been steady this calendar year, and the country's external account looks comfortable.

India's current account deficit has moderated. In October-December, the CAD narrowed to 2.2% from 3.7% in July-September because of a lower merchandise trade deficit and a robust growth in services exports.

The foreign exchange reserves are on the rise again. They are currently at $600 billion if one considers RBI's forward FX positions. Real interest rates are now well in the positive territory and enough to lure in depositors.

The one-year ahead inflation, which seems to be a preferred base for the RBI, is 5.2% and at 6.5%, the real repo rate is 130 basis points. To that extent, the pressure on the MPC to raise interest rates has ebbed.

High Bar

By opting for a pause now, the MPC has set the bar high for itself to raise interest rates again.

By not raising rates Thursday, when the previous two inflation prints were above 6%, the MPC will find it tough to raise interest rates at a time when the disinflation trend persists month after month because of the high base. The surprise inflation prints of January and February may have helped the RBI lower its FY24 inflation target to 5.2% as the base effect comes to play.

By staying hawkish with its stance and the governor issuing accompanying strong statements, RBI wanted to ensure that the market does not start pricing in rate cuts which could put paid to tightening still working through the system.

That explains why Governor Das started his press conference with an emphatic "pause" is not a "pivot" statement.

Unless geopolitical conditions worsen, capital flows into India dry up, or there is an ugly surprise in the form of a renewed surge in inflation, the RBI is unlikely to raise interest rates and, instead, will let liquidity conditions compress demand.

One can expect a prolonged pause with neutral-to-tight liquidity conditions, with the central bank avoiding injecting big chunks of durable liquidity.

The RBI may also refrain from resorting to open market operations as a first resort. It might hold off on bond purchases because it managed without OMOs last year despite the clamour from the market.

The RBI will ease up on its liquidity stance only when it changes its overall monetary policy stance. And this is only likely after the Fed pauses and core inflation falls towards 5%.

With the RBI not raising its repo rate, banks are unlikely to hike lending rates. But tight liquidity and competition from other institutions will force banks to raise deposit rates.

The RBI will likely limit its liquidity to fine-turning operations and limit being a lender of first resort to the banks. The unsaid message from RBI is that it needn't be higher for longer, but it certainly is tighter for longer.

There will be enough on offer for depositors and long-term bond investors.