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 Why interest rates may go up

  After holding on for a couple of months, the petrol and diesel prices have finally been increased. Following a nationwide Rs 3 hike in petrol and diesel prices last week, prices have again been raised this week. For instance, in Delhi, petrol is up by 87 paise and diesel by 91 paise. The price rise has been necessitated by the ongoing US-Israel war on Iran. With the conflict showing no signs of ending, crude oil prices on Tuesday were holding around $109 a barrel.

  With India dependent on imports for the bulk of its oil requirements, price hikes were imminent. This will have a ripple effect, as public transport may become expensive, freight costs increase, and higher raw material costs will pinch companies, which have already begun raising prices in recent months.

  RBI Governor Sanjay Malhotra had warned in April that the conflict could have second-order effects on inflation, and in such uncertain times, it was important to be nimble and agile, maintaining a broad policy stance.

  Even before the fuel prices had been increased, the wholesale inflation surged to 8.3 per cent in April, the highest in 3.5 years. In the coming months, retail inflation is expected to rise too. The looming El Nino weather conditions, which may affect the monsoon this year, will compound matters as food prices may also shoot up, in case of deficient rains and soaring temperatures.

  Add to that the continuous depreciation in the rupee against the US dollar, due to the geopolitical uncertainties and heavy equity market selling by foreign investors, the RBI will have little choice to raise rates, experts say. The rupee had ended at a record closing low of 96.35 against the dollar on Monday, May 18.  

  The MPC may yet choose to wait and watch in the upcoming meeting in June, but may raise rates in the subsequent policies.

 How much can the rates go up?

  "The RBI is likely to stay on pause in June. However, from subsequent policy meetings, we could begin to see rate action. We expect around 75 basis points of rate hikes during the current financial year," noted Devang Shah, head – fixed income at Axis Mutual Fund.

  So, by March 2027, the repo rate could move closer to 6 per cent from the current 5.25 per cent.

  “If rates are not hiked, the currency will come under pressure, potentially leading to a vicious cycle. Moreover, if CPI inflation rises to 5.5 per cent in the second half of the financial year, maintaining rates at 5.25 per cent would be untenable,” Shah stressed.

  Seshadri Sen, head of research and strategist at Emkay Global Financial Services, sees two scenarios from a rate hike perspective.

  “If the energy crisis subsides, then there will probably be a 25 bps hike to address the immediate short-term risk, beyond that there will be none. However, if the energy crisis does continue, it could be as much as 100 bps,” he said.

  Dhananjay Sinha, the co-head of institutional equities at Systematix, wrote after last week’s fuel price hike that it would be the beginning of a series of hikes. The initial adjustment covered only 7-8 per cent of the cumulative under-recoveries from three months of selling fuel at unchanged prices, a burden he estimated at Rs 1.7-1.8 lakh crore. With crude potentially remaining anchored above $100 per barrel, WPI inflation crossing 10 per cent was a “plausible and near-term base case,” he said.

  “While the central bank may initially look through the near-term surge in inflation, its persistence, compounded by a weakening currency, could eventually force a reversal of policy rates. That would mark a painful unwinding of the aggressively accommodative stance adopted last year, one delivered through a profusion of liquidity measures, steep rate cuts, and a significant easing of regulatory guardrails for lenders,” Sinha said.

  Puneet Pal, head of fixed income at PGIM India Mutual Fund, sees the RBI raising policy rates by 50-75 bps by the end of December 2026. Bond markets were already factoring in a rise in policy rates, he said.

  “Given the lingering geopolitical issues, constraining the central government’s fiscal position and with the state’s fiscal deficit expected to remain elevated, the supply-demand dynamics remain unfavourable, and we expect yields to keep trending higher gradually,” noted Pal.