The Reserve Bank of India (RBI) has kick-started a rate-hike cycle after nearly four years amid rising inflation risks due to a weak monsoon and surge in oil prices in the backdrop of a lingering US-Iran war.

The RBI-led monetary policy committee (MPC) on Wednesday raised the repo rate by 25 basis points to 5.50% and signaled further rate hikes on the back of global headwinds.

While the six-member rate panel voted unanimously in favour of the hike, it changed its policy stance to calibrated tightening from neutral.

The last repo rate hike was in February 2023, when the MPC raised it by 25 basis points to 6.50%.

"After a detailed assessment of the evolving macroeconomic and financial conditions, developments and the outlook, the MPC voted unanimously to increase the policy repo rate by 25 basis points," RBI Governor Sanjay Malhotra said.

Incidentally, this is the first rate hike under Malhotra. Since he took office in December 2024, he started a series of rate cuts last year, lowering it by a cumulative 125 basis points before keeping it unchanged at 5.25% for four consecutive reviews.

“The MPC observed, in light of the available data, that it is clear that inflation and its outlook are not benign as they were last year,” Malhotra said, adding that “recalibrating the policy rate” had become “an imperative.”

Policy action in the near term would be limited to either a hike or a pause depending on how the outlook evolves.

“Given the current conditions, rate cuts are off the table in the near term. Policy action ahead can only be a rate hike or a pause, depending on the evolving conditions and the outlook,” Malhotra said.

India's retail inflation has climbed to 4.82% in August and is projected to move above 5% during FY27. It is expected to peak around 5.9% in the third quarter, with added risks on account of a deficient monsoon and crude oil prices at around $100 per barrel.

"Against a backdrop of elevated oil prices, tighter global conditions, and risks to food inflation from unfavourable weather, policymakers have chosen to reinforce inflation credibility before risks become entrenched," said Radhika Rao, senior economist at DBS bank.

The RBI’s latest move brings it in line with other central banks across the world who have started tightening policy in a bid to slow rising prices. On 16 September, the US Federal Reserve raised its benchmark interest rate for the first time in over three years by 25 basis points to a target range of 3.75% to 4%, despite fierce opposition from President Donald Trump. Fed Chair Kevin Warsh said the move was because "inflation is too high and has been for too long".

The US 10-year Treasury yields have also remained elevated at around 5.3%, while the Indian rupee has been trading softer at 96.36 per US dollar.

The narrowing interest-rate differential between India and the US could have weighed on the RBI’s decision. The thinner the gap the more attractive it becomes for investors to look at the US assets. Foreign investors have pulled out a record amount from Indian equities this year.

Other central banks have also been tightening their monetary policies, citing inflationary pressures from the US-Iran conflict in the Middle East. The European Central Bank raised its three key rates by 25 basis points in September while stating that higher energy prices were likely to keep inflation above target into the first half of 2027. Upping its 2026 inflation forecast to 3%, the ECB expects it to return to its 2% target only towards the end of 2027.

The Bank of Japan also raised its policy rate in September to a 31-year high. Governor Kazuo Ueda has stressed the need to keep underlying inflation anchored around its 2% target.

The RBI's other consideration is excess liquidity, which has pushed overnight borrowing costs below the policy rate and increased the need for calibrated absorption. The RBI's special forex swap facility mobilised $132.98 billion through FCNR(B) deposits as of 31 August.

According to Bloomberg, the central bank has already drained more than Rs 1 lakh crore ($10.4 billion) through bond sales and other measures.

Economists expect further tightening of up to 75 basis points to take the repo rate to around 6% by the end of FY27, if inflation, oil prices and geopolitical conditions stay adverse.

Inflation forecast raised to 5.2% for FY27

The RBI has marginally raised the inflation forecast for FY27 to 5.2% from its earlier forecast of 5% earlier and said price pressures are increasingly becoming visible across a range of commodities.

The near-term outlook on inflation points to continued supply-side pressures due to monsoon deficit, El Nino conditions and high volatility in international crude oil prices, the RBI governor said, while announcing the October bi-monthly monetary policy.

A weaker rupee has further complicated the price stability outlook.

"Price pressures are increasingly becoming visible across a range of commodities within the food component, apart from oil," Malhotra said.

The early signs of inflation becoming generalised are also evident from the increase in core inflation and higher inflation across a larger segment of the consumer price index (CPI) basket, he added.

Considering all factors, the RBI has projected inflation at 4.9% for the second quarter; 6% for the December quarter; Q4 at 5.7%; and 5.6% for the June quarter of FY28, with risks evenly balanced.

CPI-based retail inflation rose to 4.8% in August 2026 from 4.5% in July, mainly due to higher food and fuel prices.

Core inflation has been projected at 4.4% for the current fiscal ending March 2027.

GDP growth forecast for FY27 upgraded to 7.1% amid resilience

The RBI has upgraded its GDP growth forecast for FY27 by 40 basis points to 7.1% from 6.7% earlier, while cautioning that lingering global geopolitical tensions could pose a risk to the economic outlook.

Malhotra said domestic economic activity exhibited resilience amidst global headwinds, as evident from real GDP growth of 7.8% in Q1 2026-27.

Growth was driven by strong investment and private consumption activity, while the contribution of net exports also remained positive.

Malhotra said global headwinds from protracted geopolitical tensions, elevated international commodity prices, additional frictions in global trade and tightening global financial conditions may weigh on the growth outlook.

Taking all these factors into consideration, the RBI projected real GDP growth for 2026-27 at 7.1%; Q2 at 7.2%; Q3 at 6.9%; Q4 at 6.8%; and Q1 of FY28 at 7.1%.

The RBI had earlier projected growth at 7% in Q1; 6.4% in Q2; 6.5% in Q3; and 6.8% in Q4 of FY27. In the August policy, the central bank raised its FY27 growth forecast by 10 basis points to 6.7% from 6.6%.

The upward revision in the growth forecast by 40 bps further underscores the strength of economic activity despite significant headwinds, Malhotra said.

“Growth has withstood the shocks of the West Asia war and there is more confidence now that the economy will be able to withstand a moderate tightening of policy rates,” Yes Bank chief economist Indranil Pan said in a report on 1 October.