Mint ·
Economy, business and finance
Markets shift to rate-hike mode after US Fed's hawkish turn
Markets will closely watch the 7-October meeting, where the Reserve Bank of India’s rate-setting panel is expected to end its almost year-long easing cycle with a 25-basis-point hike.
Indian markets are bracing for monetary policy tightening, with expectations of a half-percentage-point repo rate hike by December strengthening after the US Federal Reserve raised rates by a quarter percentage point and signalled another hike later this year.
Markets will closely watch the 7-October Monetary Policy Committee (MPC) meeting, where the Reserve Bank of India’s (RBI’s) rate-setting panel is expected to end its almost year-long easing cycle with a 25-basis-point (bp) rate hike, according to at least five market participants. One basis point is one-hundredth of a percentage point.
The market participants expect the central bank to raise the rate at which it lends short-term funds to banks again in December as the global policy mood turns hawkish.
On Wednesday, the US Federal Open Market Committee (FOMC) raised rates for the first time since 2023 to 3.75-4.00%, as consumer inflation remained above the Fed’s 2% target at 3.4% in August for the second month, driven by higher energy prices amid the West Asia war, tariff increases and strong demand linked to the artificial-intelligence (AI) boom.
Until over a week ago, an October rate hike was not firmly priced into market expectations. However, that has changed following the US Fed’s move, as well as RBI’s recent measures to absorb excess liquidity from record foreign-currency inflows through a dedicated window.
“The global rate backdrop has turned decisively less benign, with the US Fed hiking 25bps and the Bank of Japan (BoJ) moving towards further normalization amid elevated US yields. Against this, RBI’s liquidity absorption through variable rate reverse repo (VRRRs), foreign exchange swaps and open-market operations (OMO) sales signals a clear shift to liquidity normalization and could be a precursor to a rate hike,” said V.R.C. Reddy, treasury head at Karur Vysya Bank Ltd.
Reddy added that the next meeting could mark the beginning of a cautious tightening phase, with a 25bps hike in October and another in December becoming a distinct possibility if external pressures persist.
While the Fed’s 25bps rate hike was broadly in line with market expectations, its forward guidance has reinforced a hawkish tone.
The Fed’s projections point to another 25bps hike this year, while the 2027 median projection keeps rates elevated, with eight Fed officials seeing scope for further hikes and four projecting easing, according to financial services and capital markets firm Emkay Global Financial Services.
The US rate-hike cycle could increase pressure on RBI to maintain attractive interest-rate differentials, particularly with crude prices staying elevated, the Indian rupee under pressure, and foreign portfolio investor (FPI) flows weakening, Reddy said.
Currently, the yield gap between the 10-year US Treasury and Indian government bond yields stands at 207bps, down from 238bps at the beginning of 2026, Bloomberg data showed.
After the Fed’s hike, the yield on the 10-year US Treasury rose by 2bps to 5.02% on Wednesday, then eased to 4.98% by the end of the day. Yield on the Indian government bond with a similar maturity rose by 2bps to 7.07% on Thursday.
The global policy tide has turned hawkish. As the US Fed, the European Central Bank, and the BoJ signal tighter policy and global yields rise, India has limited room for policy divergence, according to a 17-September report by Axis Capital’s Economic Research.
“Rate hikes are thus inevitable…The Fed’s latest hike and dot plot strengthen the case for 50bps of RBI tightening in 2026, split between October and December. We expect the overall hiking cycle to be limited to 75bps,” the report said.
While headline inflation has risen sharply, core inflation still remains steady. RBI’s mandate is to target headline inflation, but focusing on headline inflation forecasts may miss underlying trends, the report said, adding that the risk of second-round effects is rising and that a sectoral supply shock can transform into broader inflation if monetary or fiscal policies actively accommodate it.
India’s retail inflation rose to a 20-month high of 4.82% in August, driven by higher food and fuel prices, moving above RBI's 4% target midpoint for the third consecutive month. Core inflation came in at 4.2%, as against 3.9% in July. India, however, recorded robust real gross domestic product (GDP) growth of 7.8% in the June quarter, up from 6.9% a year ago.
Madhavi Arora, chief economist at Emkay Global, also expects the October decision to be the beginning of a shallow tightening cycle. “A 25bps hike in October by RBI looks more likely, but we also expect this to be a shallow hiking cycle of 50-75bps,” she said.
In the near term, RBI’s focus is likely to remain on draining surplus liquidity and bringing overnight rates, currently 45bps below the policy rate, back into alignment with it, the report said.
Banks mobilized a record $127.22 billion through Foreign Currency Non-Resident (Bank), or FCNR(B), deposits under RBI’s foreign-exchange swap facility before it closed on 31 August, a month ahead of its original deadline. Together with $5.26 billion raised through overseas foreign currency borrowings and $3.89 billion through external commercial borrowings, the facility attracted $136.37 billion of inflows.
As of 16 September, surplus liquidity stood at ₹7.37 trillion, compared with over ₹10 trillion for most of the month so far.
For bonds, the implication is a potentially limited rise in yields if the cycle remains shallow. Reddy expects the 10-year government bond yield to settle around 7.15-7.20%, with the 7.10-7.20% levels potentially emerging as a zone to lock in, subject to demand and supply.
He cautioned, however, that heavy state-government borrowing in the second half of FY27, and any additional central-government borrowing if the fiscal deficit slips, could put greater pressure on bonds through December and into early 2027.
India's fiscal deficit in April-July stood at ₹4.55 trillion, or 26.8% of the target for FY27, compared with ₹4.7 trillion in the year-ago period. India has set its fiscal deficit target for FY27 at 4.3% of GDP, or ₹16.96 trillion.