After a widely expected pause by RBI, what is the road ahead for interest rates?

The Reserve Bank of India's monetary policy committee (MPC) expectedly left its benchmark repo rate on hold at 6.50 per cent for the fourth consecutive time, which means borrowers will likely continue to see some stability in their interest rates and loan EMIs. After all, between May 2022 and February 2023, the central bank had raised the benchmark rate at which it lends to commercial banks by 2.50 per cent (250 basis points). But, even as the MPC left interest rates unchanged, there are enough signs that rates will continue to remain on the higher side for the forseeable future.

Inflation remains a key challenge ahead for RBI. After hitting a 15-month high of 7.44 per cent in July, CPI (consumer price index) inflation declined to 6.83 per cent in August. But, that is still above the upper end of RBI's 2 to 6 per cent target band. RBI Governor Shaktikanta Das has stressed that aligning inflation to the 4 per cent target is the focus. This suggests that merely getting inflation below 6 per cent may not be enough.

RBI's CPI inflation projection for the current financial year is at 5.4 per cent. Even in the April-June quarter of 2024, RBI is expecting inflation to still be at 5.2 per cent, which is well above 4 per cent.

There are several risks ahead. One, the area under pulses cultivation in the Kharif crop season is below last year's level. Secondly, El Nino weather conditions and volatile energy and food prices in the global markets will also weigh. Thirdly, rainfall has been uneven this year and low reservoir levels could well impact the Rabi crop season ahead.

Furthermore, the actions of global central banks will also have to be watched out for. The US Federal Reserve also kept interest rates on hold last month, but a lot of commentators saw it as a "hawkish pause" and that it may not yet be the end of rate hikes. The European Central Bank, did in fact, raise interest rates last month to a record high 4 per cent.

Governor Shaktikanta Das pointed out in his comments that the transmission of the earlier 250 bps rate hikes still remained incomplete. As per RBI data, the weighted average domestic term deposit rate on fresh deposits of scheduled commercial banks and the weighted average lending rate on fresh loans have increased by 233 bps and 196 bps respectively in the current tightening cycle. The corresponding increase in outstanding term deposit rates and outstanding lending rates is even lower at 157 bps and 112 bps, respectively.

Economists were already baking in the fact that the RBI was unlikely to cut interest rates through this year. And RBI's commentary post the latest MPC meet only sends further signals that interest rates could remain on the higher side for a long period.

"Food inflation remains a key monitorable not only because it is in double digits, but also because sub-normal monsoon and muted sowing can impact kharif output and prices. Additionally, low reservoir levels do not augur well for the rabi crops," said Dharmakirti Joshi, chief economist at CRISIL.

He expects rates to remain at these levels and foresees a rate cut perhaps only in the first quarter of the next financial year.

Aurodeep Nandi, India economist and vice-president at Nomura Securities, says Friday's policy announcement had an element of deja vu - both the policy rate and stance were retained, as were the GDP growth and inflation forecasts for the year, while markets were reminded that the RBI remains alert to act on upside inflation risks and that 4 per cent inflation target is sacred.

"Global and domestic uncertainties dictate that the RBI remains nimble and alert to the risk of higher inflation. The RBI also flagged that liquidity remains too skewed and as in the previous policy meeting, the leash on liquidity remains tight, with the RBI stating that it may consider OMO (open market operations) sales. Overall, this is a hawkish pause - replayed," said Nandi.

According to Sampath Reddy, chief investment officer at Bajaj Allianz Life Insurance, given recent inflationary pressures driven by food and vegetable prices in India, the extended tightening measures by global central banks and the RBI's commitment to lower domestic inflation to 4 per cent, the outlook for interest rates remains cautious in the near-term.

The possibility of (OMO bond) sales to manage liquidity may pose short-term pressure on interest rates, he feels.

"We believe that RBI's future actions will depend on evolving data, and we continue to expect a long pause," he said.

RBI will maintain tighter liquidity conditions to address higher inflation risks, says Amit Somani, senior fund manager - fixed income, Tata Asset Management.

"Short-term rates are likely to remain elevated in near-term factoring in tighter liquidity conditions going forward. RBI would target inflation rate of 4 per cent and not 2 per cent to 6 per cent range, again signals the policy rates to remain higher for longer," he opined.

Siddhartha Sanyal, chief economist and head of research at Bandhan Bank, also said the status quo on policy rates was no surprise and that softening of agro commodities after a sharp spike in prices in the first half of the July-September quarter had offered the central bank some breathing space.

"However, the MPC looks set to stay cautious given rising risks in the global macro backdrop and possibility of further hikes by global central banks later this year. The RBI's reiteration of their commitment to the CPI target of 4 per cent further underscores this point as rates look set to stay higher for longer," he said.

Rajan Jain, head - credit research at SBI Capital Markets, said RBI's emphasis on 4 per cent inflation target implied that the "timeline for potential rate cuts may extend deep into FY2025, possibly beyond first quarter."

A vigilant focus on domestic liquidity and robust foreign exchange reserves mitigates the impact of global risks and lowers the probability of RBI policy rate hike, added Jain.

Suvodeep Rakshit, senior economist, Kotak Institutional Equities, also sees a prolonged pause on repo rate at 6.5 per cent well into the next financial year.