India is approaching an uncomfortable turning point in monetary policy. With the Reserve Bank of India (RBI) holding the repo rate at 5.25% while inflation rises, the real policy rate is steadily losing its cushion. Consumer price inflation rose to 4.82% in August, from 4.45% in July, marking the third consecutive month above the RBI’s target of 4%. Food inflation is even higher at 5.95%. Core inflation has also risen to around 4.2%, suggesting that price pressures are broadening beyond food.

A view on the real interest rate is not obtained simply by subtracting yesterday’s inflation from today’s policy rate. Monetary policy operates through expected inflation. If the repo rate remains at 5.25% while inflation expectations move towards 5.25%, the ex-ante real policy rate becomes approximately zero. That is a very different monetary environment from the one in which the real policy rate is comfortably positive.

Closer to zero real rates

India is now much closer to that point than it appeared after the August policy. The RBI maintained a neutral stance, while projecting FY2026-27 inflation at around 5%. However, the latest inflation reading has moved beyond the RBI’s projected average trajectory for the year: headline inflation is already 4.82%, while food inflation is 5.95%.

Therefore, if inflationary pressure maintains the current momentum and external pressure aggravates, India could soon find itself in a zero real interest rate environment.

The risks surrounding that trajectory are hardly trivial. The monsoon remains an important source of uncertainty. More importantly, India is confronting a potentially powerful external inflation shock. Renewed conflict in West Asia has disrupted shipping through the Strait of Hormuz and pushed Brent crude above $100 a barrel, with prices approaching $110. The combination of higher oil prices, a weaker rupee and elevated global commodity prices creates a substantially more difficult inflation environment.

Falling real rates are often thought to stimulate demand and credit when the economy is operating below capacity. However, when demand is already healthy, and the inflation shock originates from supply and expectations, the same mechanism can amplify rather than neutralise inflation.

Banking system trends

India’s banking system makes the issue even more interesting because the zero real rate is not transmitted symmetrically to borrowers and savers. Bank credit growth stood at 19.1% year-on-year at the end of August and remains exceptionally strong.

Deposits, however, have also surged. Deposit growth reached 17.8% at the end of August, the fastest pace in a decade, partly because of the RBI’s special FCNR(B) mobilisation scheme. The increase, therefore, needs careful interpretation: it does not necessarily indicate that domestic households have suddenly become more willing to hold conventional bank deposits. Instead, much of the increase reflects foreign currency inflows under the special scheme. The credit-deposit ratio was around 80.3% at the end of August.

India is consequently experiencing strong credit demand even as banks compete for stable domestic deposits. Households increasingly have alternatives to bank deposits, including mutual funds and equities. When inflation rises, the real return on conventional deposits becomes less attractive, giving savers a greater incentive to move towards market-linked assets, gold or other inflation hedges. Empirical evidence from India underscores the importance of this channel. RBI research on the earlier inflation episode found that rising inflation and inflation expectations reduced the real return on household financial savings. During the high-inflation period from 2010 to 2013, real returns on savings instruments became negative and household financial savings weakened, while demand for gold increased substantially. The correlation between gold imports and household inflation expectations was estimated at 0.83 over the period studied.

Therefore, did the RBI miss an opportunity to react earlier? A central bank should not raise rates simply because oil prices have increased. Yet, it must consider the risk that temporary inflation becomes embedded in expectations, wages, prices and credit.

That risk now looks more real. Inflation has remained above 4% for three consecutive months, and August’s 4.82% reading was accompanied by a rise in core inflation to around 4.2%, while the one-year OIS rate is around 6%, signalling expectations of some future tightening. At the same time, GDP growth is running at 7.8%, and bank credit is growing at 19.1%. Demand is hardly weak.

The issue is about timing

A 5.25% repo rate may therefore appear restrictive in nominal terms, but offers increasingly little restraint in real terms. The real issue, therefore, is timing. In monetary policy, timing is an instrument in itself. A timely 25-basis-point adjustment may ultimately cost less than a delayed 50-basis-point correction. Importantly, the direction is clear — inflation is moving toward the policy rate while growth and credit remain strong. Perhaps the time has come.

Saumitra Bhaduri is a professor at the Madras School of Economics.