The Hawkish Case, Why the MPC Should Have Hiked Rates

The Hawkish Case, Why the MPC Should Have Hiked Rates

The Monetary Policy Committee (MPC) has decided to hold the policy rates unchanged in the April monetary policy, which remains largely in consonance with market expectations. In the last few months, as conflict in West Asia intensified and fuel pangs were brought home, two differing views emerged on the likely impact on India: first, our economy is resilient and domestic demand-driven which will keep it afloat and on track of growth trajectory even with rupee declines; and second, the current account deficit and rupee woes will jeopardise the growth dynamics. Both views can be tempered and calibrated with an integrated view of domestic forward-looking indicators and external sector dynamics. A closer examination of business inflation expectations, credit growth patterns, and rupee dynamics suggests that a pause may have been a missed opportunity. High inflation expectations, leveraged asset demand, and a depreciating rupee are good reasons to hike rates. The MPC should have tilted hawkish.

The Build-Up of Inflation Expectations

First, firm level forward looking indicators clearly suggest a build-up of inflation expectations. With rupee depreciation and consequent rising fuel costs would impact firms first, making them the primary transmission channel of external shocks. The latest data from Business Inflation Expectations Survey (BIES), conducted monthly by IIMA, that polls a panel of business leaders about their inflation expectations in the short and medium term, shows a marked increase in inflation expectations.

The one year ahead business inflation expectation recorded in March 2026 has shot up sharply by 100 basis points (bps) to 5.29 per cent, from 4.29 per cent recorded in February 2026. This is the highest ever monthly increase during the past nine years of the BIES. A 100 basis point jump in a single month is not a marginal adjustment; it is a signal. Business leaders across sectors are expecting significantly higher inflation in the coming year. They will act on those expectations: raising prices, building inventory, demanding higher wages. Inflation expectations can become self-fulfilling.

The uncertainty of business inflation expectations has remained elevated by over 2 per cent during February-March 2026. The RBI in its monetary policy statement has also projected one year ahead CPI inflation to be in the range of 4-5 per cent with an upward risk. The latest data shows Consumer Price Index (CPI) inflation climbed to a 13-month high of 3.4 per cent in March, an increase from the 3.2 per cent recorded in February. Inflation is not yet at alarming levels, but the trajectory is upward.

The Historical Lesson: The 1970s Precedent

The rate hikes show consumer waiting for prices and wages to adjust in the labour market may not be the best option at this point in time. The historical experience suggests a rate cut or rate pause at this stage may not have desired impact. The 1970s experience clearly indicates the only way to prevent inflation from thwarting the limited growth prospects in the medium term is targeting inflation first. Immediate growth sacrifice is a better option before inflation becomes deeply entrenched.

In the 1970s, central banks around the world faced an oil price shock similar to today’s. They chose to accommodate the shock, allowing inflation to rise rather than risking a recession. The result was stagflation: high inflation and high unemployment simultaneously. It took a decade of painful rate hikes under Paul Volcker at the Federal Reserve to break the back of inflation. The lesson is clear: letting inflation become entrenched is far more costly than raising rates pre-emptively.

India’s MPC should learn from that lesson. The current inflation is not yet entrenched. But the expectations are building. The transmission from fuel prices to core inflation is underway. If the MPC waits too long, it may have to raise rates even more steeply later, causing greater damage to growth.

The Global Context: A Hawkish Tilt

Globally we are seeing a move towards a hawkish tilt, with both Federal Reserve and ECB holding rates steady yet cautioning against inflation driven risks. Markets are repricing this possibility of tightening, and Bank of Japan continues with a tightening phase. The Federal Reserve has signalled that it is in no hurry to cut rates. The European Central Bank has warned of upside risks to inflation. The Bank of Japan has finally exited its negative interest rate policy. The global tide is turning against easy money.

India cannot afford to be an outlier. If major central banks are tightening or holding steady, capital will flow to where returns are higher and risks are lower. A pause by the RBI, when others are tightening, makes Indian assets less attractive. It puts downward pressure on the rupee and upward pressure on imported inflation.

Why an Interest Rate Hike Would Have Been the Right Approach

There are two reasons at least why an interest rate hike would have been the right approach.

First, as iterated by the RBI Governor, while credit growth has improved consistently, higher credit offtake might suggest either overoptimistic exuberance or leverage building. This would therefore be the right time for countercyclical policies. With sectors like real estate, gold and personal loans continuing to lead credit growth, a possibility of over-exuberance in face of inching inflation and muted growth suggests tightening would be prudent.

Real estate prices have been rising. Gold loans are booming. Personal loans are growing at double-digit rates. This is not credit for productive investment; it is credit for consumption and speculation. When inflation rises and growth slows, highly leveraged households and firms are vulnerable. A pre-emptive rate hike would cool the froth before it becomes a crisis.

Secondly, a rate hike would have helped to stall rupee depreciation. Interventions with regard to the rupee generally need to be kept to a minimum. First, not only would spot market interventions reduce liquidity, it could push up inflation if followed up with liquidity infusion measures. Second, forward market interventions would build up dollar liabilities in the future, which given the geopolitical situation can be avoided. Indirect intervention measures to regulate actions of market participants can lead to greater speculation.

When the RBI sells dollars to prop up the rupee, it sucks rupees out of the system. To prevent a liquidity crunch, it must then inject rupees through open market operations or other tools. The net effect is ambiguous. Forward market interventions create future obligations. If the rupee depreciates further, those obligations become more expensive. Speculators know this and may bet against the currency, knowing that the RBI’s firepower is limited.

A rate hike, by contrast, directly attracts foreign capital. Higher interest rates make Indian bonds more attractive to foreign investors. The resulting capital inflows support the rupee without the need for intervention. Even if the rate hike is modest, it signals that the RBI is serious about inflation, which builds confidence in the currency.

A rate hike would also help banks to make policies like FCNR (B) more attractive to attract capital flows. Foreign Currency Non-Resident (Bank) deposits are a stable source of foreign exchange. But they are sensitive to interest rate differentials. A higher repo rate would allow banks to offer higher rates on FCNR deposits, attracting more inflows.

The Trade-Off: Growth vs. Inflation

The MPC faces a classic trade-off: raising rates could slow growth; holding rates could allow inflation to accelerate. The article’s argument is that the inflation risk is greater than the growth risk. The economy is growing at 6-7 per cent. A temporary slowdown to 5-6 per cent would be painful but manageable. But if inflation becomes entrenched, the RBI would have to raise rates even more later, causing a sharper slowdown. The immediate sacrifice is worth preventing a deeper crisis.

Thus, a tilt on the hawkish side would have been more consistent with the flexible inflation targeting framework. The framework gives the RBI a mandate to keep inflation within a band of 2-6 per cent, with a medium-term target of 4 per cent. With inflation at 3.4 per cent and rising, and expectations at 5.29 per cent, the RBI is within its rights to act pre-emptively. Waiting for inflation to breach the upper band before acting is not flexible inflation targeting; it is reactive inflation targeting.

Conclusion: A Missed Opportunity

The MPC’s decision to hold rates was not a mistake in the sense of being obviously wrong. Reasonable people can disagree. But the balance of evidence suggests that a hike would have been prudent. Inflation expectations are rising sharply. Credit growth is being driven by speculative sectors. The rupee is under pressure. Global central banks are tilting hawkish. The historical lesson of the 1970s is clear: act early, or pay later.

The RBI has built credibility over the past decade as an inflation-fighting institution. That credibility is a valuable asset. It allows the RBI to keep inflation expectations anchored even when actual inflation rises. But credibility is not permanent. It must be maintained. A pause when a hike was warranted could erode that credibility. Businesses and households might start expecting higher inflation, and those expectations could become self-fulfilling.

The April policy was a missed opportunity. The next policy meeting should not be.

Q&A: Should the MPC Have Hiked Rates?

Q1: What does the Business Inflation Expectations Survey (BIES) data show, and why is it significant?

A1: The BIES, conducted monthly by IIMA polling business leaders, shows that one year ahead business inflation expectations recorded in March 2026 shot up sharply by 100 basis points to 5.29 per cent, from 4.29 per cent in February 2026. This is the “highest ever monthly increase during the past nine years of the BIES.” The significance is that business leaders across sectors expect significantly higher inflation and will act on those expectations—”raising prices, building inventory, demanding higher wages.” Inflation expectations can become “self-fulfilling.” The RBI has projected one year ahead CPI inflation in the range of 4-5 per cent with upward risk, and actual CPI inflation climbed to a 13-month high of 3.4 per cent in March.

Q2: What lesson does the article draw from the 1970s experience with inflation?

A2: In the 1970s, central banks faced an oil price shock similar to today’s. They chose to “accommodate the shock, allowing inflation to rise rather than risking a recession.” The result was “stagflation: high inflation and high unemployment simultaneously.” It took a decade of painful rate hikes under Paul Volcker to break inflation. The lesson: “letting inflation become entrenched is far more costly than raising rates pre-emptively.” The article argues that “immediate growth sacrifice is a better option before inflation becomes deeply entrenched.” The current inflation is not yet entrenched, but expectations are building. If the MPC waits too long, it may have to raise rates “even more steeply later, causing greater damage to growth.”

Q3: What are the two main reasons the article gives for why a rate hike would have been the right approach?

A3:

1. Countercyclical policy against credit exuberance: Credit growth is being led by “real estate, gold and personal loans”—not productive investment but “consumption and speculation.” Higher credit offtake suggests “either overoptimistic exuberance or leverage building.” A pre-emptive rate hike would “cool the froth before it becomes a crisis.”

2. Stall rupee depreciation: A rate hike would “directly attract foreign capital” as higher interest rates make Indian bonds more attractive, supporting the rupee without intervention. Spot market interventions reduce liquidity and could push up inflation; forward market interventions build up future dollar liabilities. Indirect intervention measures “can lead to greater speculation.” A rate hike also helps banks make policies like FCNR (B) more attractive to attract capital flows.

Q4: What is the global context regarding monetary policy, and why does it matter for India?

A4: Globally, there is a “move towards a hawkish tilt.” The Federal Reserve and ECB are “holding rates steady yet cautioning against inflation driven risks.” Markets are repricing the possibility of tightening. The Bank of Japan “continues with a tightening phase.” The article warns that India cannot afford to be an outlier: “If major central banks are tightening or holding steady, capital will flow to where returns are higher and risks are lower. A pause by the RBI, when others are tightening, makes Indian assets less attractive. It puts downward pressure on the rupee and upward pressure on imported inflation.”

Q5: How does the article characterise the MPC’s decision to hold rates, and what is its conclusion?

A5: The article characterises the decision as a “missed opportunity.” While not “obviously wrong,” the “balance of evidence suggests that a hike would have been prudent.” The RBI has built credibility as an inflation-fighting institution, but “credibility is not permanent. It must be maintained. A pause when a hike was warranted could erode that credibility.” The article concludes that “a tilt on the hawkish side would have been more consistent with the flexible inflation targeting framework.” The framework gives the RBI a mandate to keep inflation within a band of 2-6 per cent, with a medium-term target of 4 per cent. With inflation at 3.4 per cent and rising, and expectations at 5.29 per cent, the RBI is “within its rights to act pre-emptively. Waiting for inflation to breach the upper band before acting is not flexible inflation targeting; it is reactive inflation targeting.” The April policy was a missed opportunity; “the next policy meeting should not be.”