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Economy, business and finance
Liquidity normalisation key before RBI embarks on interest rate hikes
With global central banks raising rates, RBI may need to drain excess banking liquidity and align overnight rates with the repo rate before embarking on a fresh tightening cycle
5 min read Last Updated : Sep 17 2026 | 11:14 PM IST
With global central banks such as the European Central Bank (ECB) and US Federal Reserve raising interest rates, the Reserve Bank of India (RBI) may feel compelled to do its bit at the next monetary policy review scheduled for October 5-7.
In the minutes of the August review meeting, members of the domestic rate-setting panel had indicated the need to recalibrate rates as inflation was becoming generalised.
On Wednesday, the US Federal Reserve raised interest rates for the first time since 2023, while the European Central Bank raised rates last week for the second time in 2026. The Bank of Japan is widely expected to raise rates to a 31-year high on Friday.
The spread between comparable US and Indian securities has narrowed in the last few months. “The Dot Plot has turned hawkish, with the median policy rate revised to 4.1 per cent in 2026 (3.8 per cent earlier) and 4.1 per cent in 2027 (3.6 per cent earlier), with 16 members seeing at least one more (25 basis points) hike in 2026,” ICICI Bank said in a note. “If inflation remains elevated and fails to moderate towards the 2 per cent objective as projected, we would not rule out another rate hike of 25 basis points (bps) in 2026,” it added.
However, before the RBI embarks on a rate-hike cycle, which is expected to be shallow at 50-75 bps, it faces the uphill task of making monetary transmission effective, that is, ensuring that a policy repo rate hike is passed on to various segments of the financial markets. The last rate hike by the RBI was in February 2023.
For transmission to be effective, the first step is to ensure that the weighted average call rate (WACR) — the operating target of monetary policy — aligns with the policy repo rate, which is currently at 5.25 per cent.
The WACR has been languishing at the lower end of the policy corridor, at 5 per cent. The upper end of the corridor is the Marginal Standing Facility rate, at 5.5 per cent.
This is because of the huge liquidity surplus in the banking system, thanks to non-resident Indians (NRIs) who poured in money through Foreign Currency Non-Resident (Bank), or FCNR(B), deposits after the central bank announced a concessional swap facility for banks in June. The move prompted commercial banks to offer attractive rates along with leverage. Banks mobilised $127.2 billion through such deposits until August 31, when the scheme closed. Total inflows, including External Commercial Borrowing (ECB) and Overseas Foreign Currency Borrowing (OFCB), stood at $136.4 billion. The ECB and OFCB swap scheme is open until December 31.
“Capital inflows via the FCNR route have surprised materially on the upside. Higher-than-expected dollar flows mean a surge in the liquidity surplus. Liquidity surplus reached ₹9.85 trillion as of September 15, with the operating target of the call money rate hovering at the lower end of the policy rate corridor,” said Aastha Gudwani, India chief economist at Barclays.
Initially, the RBI tried to suck out excess liquidity through variable rate reverse repo (VRRR) auctions, including longer-tenure ones, but realised they were not working as banks were reluctant to park funds for longer periods. With round-the-clock digital transaction facilities available to customers, banks find it tough to predict liquidity needs over a longer period, such as 30 days.
Now, the RBI has announced open market operation (OMO) bond sales to mop up excess liquidity, which is more durable in nature. The ₹1 trillion OMO will be conducted in three tranches, starting Thursday, in September.
According to the latest data, net durable liquidity surplus stood at ₹10.66 trillion as of August 31 and is expected to have risen to ₹14 trillion by the middle of the month. Banking system liquidity — measured by banks parking funds with the RBI’s liquidity adjustment facility — which was hovering around ₹10 trillion this month, fell to ₹7.4 trillion on Wednesday, mainly due to corporate advance-tax outflows.
The market expects more OMO sales will be required, even if festive-related spending takes care of a portion of the liquidity surplus.
Commenting that liquidity normalisation would be an important prerequisite for further policy-rate increases, Prateek Ancha, chief economist at Axis Capital, said: “Banking system liquidity remains elevated at around ₹10 trillion, with the RBI potentially needing to absorb another ₹4 trillion before overnight rates consistently track the policy rate.”
The OMO sales are not without consequences. Bond yields jumped following the announcement, with the 10-year yield rising above 7 per cent to trade at a four-month high.
“We expect the RBI to continue with liquidity-tightening measures to absorb the unintended increase in the liquidity surplus. The RBI has a large toolkit to address this liquidity overhang. The long-dated VRRR and OMO sales indicate that all options are on the table. We expect more OMO sales (especially of soon-to-mature papers) to continue and do not rule out swaps,” Barclays’
Gudwani said.
She added that how much liquidity the RBI chooses to let float in the system and what measures are used to absorb it will be key to watch in the runup to the October meeting.