Monetary policy and the RBI

The first principle

A central bank cannot set the prices of goods, but it can set the price of short term money, and every other interest rate in the economy is built on that price. By making money dearer or cheaper it slows or speeds up borrowing and spending, and so, with a lag of several quarters, inflation and output. The power works only if people believe the central bank will act, which is why a clear target, a rule bound committee and open communication matter as much as the rate itself.

The core

The framework

• Flexible inflation targeting is India's monetary framework. The Reserve Bank of India (RBI) Act 1934 was amended by the Finance Act 2016 to give monetary policy a statutory objective: price stability while keeping in mind the objective of growth. It followed the Urjit Patel Committee of 2014, which recommended the consumer price index (CPI) as the anchor, and a Monetary Policy Framework Agreement signed by the government and the RBI in February 2015.
• The target is set by the Central Government in consultation with the RBI once every five years under Section 45ZA: CPI inflation of 4 per cent with a tolerance band of 2 to 6 per cent. First notified in August 2016, it was retained for April 2021 to March 2026, and the MPC continues to work to the same 4 per cent target in 2026-27. It is flexible because the RBI may let inflation stray within the band to cushion growth after a shock.
• Accountability. If average CPI inflation stays above 6 per cent or below 2 per cent for three consecutive quarters, the RBI has failed the target and must report to the government the reasons, the remedial action and the time it needs; this happened for the first time for January to September 2022.

The Monetary Policy Committee

• The Monetary Policy Committee (MPC) has six members: the Governor as chair, the Deputy Governor in charge of monetary policy, one RBI officer nominated by the central board, and three external experts appointed by the Central Government for four years, who cannot be reappointed. Each member has one vote, and the Governor has a casting vote in a tie.
• It meets at least four times a year and in practice six times, with a quorum of four, and publishes its resolution on the day of the decision and the minutes, with each member's vote and reasons, on the fourteenth day.
• The MPC decides two things: the repo rate and the stance, which signals the likely direction of the next moves, such as accommodative, neutral or tightening.

The instruments

• The repo rate is the rate at which the RBI lends overnight to banks against government securities, and it is the policy rate. Under the liquidity adjustment facility, banks with spare money park it with the RBI at the standing deposit facility (SDF), introduced in April 2022 at repo minus 0.25 percentage point and needing no collateral, while banks short of money borrow overnight at the marginal standing facility (MSF), repo plus 0.25 percentage point, and may dip into their statutory liquid assets to do so. The bank rate is aligned with the MSF.
• The corridor formed by the SDF floor and the MSF ceiling keeps the weighted average call money rate, the operating target, close to the repo rate.
• Reserve requirements. The cash reserve ratio (CRR) is the share of net demand and time liabilities a bank must keep as cash balances with the RBI, earning no interest; it was cut in steps from 4 to 3 per cent between September and November 2025. The statutory liquidity ratio (SLR), 18 per cent, is the share a bank must hold in liquid assets such as government securities, cash and gold.
• Liquidity tools. Open market operations, the purchase or sale of government securities, add or drain durable liquidity; variable rate repo and reverse repo auctions fine tune it; and foreign exchange swaps add or absorb rupees.

Transmission: how a repo change reaches a borrower

• Lending benchmarks. Banks have priced loans off the benchmark prime lending rate (2003), the base rate (2010) and the marginal cost of funds based lending rate (MCLR, April 2016), all of which moved slowly because they depended on each bank's own cost of funds. From 1 October 2019 the RBI required new floating rate loans to individuals and micro and small enterprises to be linked to an external benchmark, usually the repo rate, which made transmission faster.
• A worked example. A home loan of Rs 50 lakh for 20 years is priced at repo plus a spread of 2.75 percentage points, so at a repo rate of 5.25 per cent it costs 8.00 per cent and the equated monthly instalment (EMI) is about Rs 41,822. When the repo rate rises by 25 basis points to 5.50 per cent, the loan rate becomes 8.25 per cent and the EMI rises to about Rs 42,603, or Rs 781 a month more. If the bank keeps the EMI unchanged instead, the tenure stretches from 240 months to about 252.

Dimensions

• Channels. A rate change works through the interest rate channel (borrowing costs), the credit channel (banks' willingness to lend), the exchange rate channel (a higher rate attracts capital and strengthens the rupee, cheapening imports), the asset price channel (bond and share prices and household wealth) and the expectations channel.
• Growth and inflation. Tightening lowers inflation by slowing demand, so it costs some output in the short run; flexible targeting tries to balance the two, which is why the RBI looks through a temporary supply shock but acts when it spreads to core prices and expectations.
• Fiscal. Large government borrowing can push up yields and weaken the RBI's control, a risk called fiscal dominance, while the end of automatic monetisation of deficits in 1997 and the ban on RBI subscription to primary government issues under the Fiscal Responsibility and Budget Management Act from 2006 strengthened its independence.
• External. Rate moves by the United States Federal Reserve shift capital flows and the rupee, so the RBI watches the interest differential and uses its foreign exchange reserves to smooth volatility.
• Financial stability. Very low rates for long can feed asset bubbles and risky lending.

In practice

• The present position. On 7 October 2026 the MPC unanimously raised the repo rate by 25 basis points to 5.50 per cent, the first increase since February 2023, so the SDF rate is now 5.25 per cent and the MSF rate and bank rate 5.75 per cent; by a majority, with two members preferring to stay neutral, it changed the stance from neutral to calibrated tightening (RBI, Monetary Policy Statement, October 2026). It had held the rate at 5.25 per cent with a neutral stance at its meetings of April, June and August 2026. It projected CPI inflation of 5.2 per cent and growth of 7.1 per cent for 2026-27.
• Why it tightened. CPI inflation, on the new base of 2024, rose from 2.75 per cent in January 2026 to 4.8 per cent in August, the last reading before the meeting, as food price rises became more broad based, with volatile crude oil prices as a further risk; core inflation rose to 4.2 per cent (RBI, October 2026), and wholesale inflation reached 11.39 per cent in September.
• The cycle before. The RBI raised the repo rate from 4.00 per cent in May 2022 to 6.50 per cent by February 2023 to fight post pandemic inflation, held it there for two years, and then cut it by a total of 125 basis points through 2025 to 5.25 per cent as inflation fell well below target, while also cutting the CRR to 3 per cent to release liquidity.

Issues and way forward

• Incomplete transmission. Loans priced on the MCLR and fixed deposit rates adjust slowly, and administered small savings rates compete with bank deposits; extending external benchmarks and aligning small savings rates with market yields, as the formula of the Shyamala Gopinath Committee of 2011 intended, would help.
• Supply shocks. Food and fuel prices, which the RBI cannot control, drive much of headline inflation; supply side measures in storage, trade and energy must accompany monetary policy, otherwise rates rise to fight shocks they cannot fix.
• Fiscal and monetary coordination. High public borrowing keeps long term rates up and crowds out private credit, so a credible path of fiscal consolidation makes the RBI's task easier.
• Data and communication. The move to a new CPI base in 2026 changes how inflation is read, and markets react to every word, so clear forward guidance and consistent data are part of policy.
• Global spillovers. Sudden capital outflows when advanced economies tighten can weaken the rupee and import inflation; adequate reserves and a flexible exchange rate are the buffers.

Common confusions

• Repo, SDF and MSF. The repo rate is the policy rate for collateralised lending to banks; the SDF is the floor at which banks deposit surplus money without collateral; the MSF is the penal ceiling for emergency overnight borrowing.
• CRR and SLR. CRR is cash kept with the RBI and earns nothing; SLR is held by the bank itself in liquid assets such as government securities, which do earn interest.
• Stance and rate. The rate is what the MPC sets today; the stance tells markets which way it is likely to move next.
• Monetary and fiscal policy. Monetary policy, run by the RBI, works through money and interest rates; fiscal policy, run by the government, works through taxes, spending and borrowing.

For the exam

• Keyword bank: flexible inflation targeting, Section 45ZA, Monetary Policy Committee, repo rate, standing deposit facility, marginal standing facility, policy corridor, cash reserve ratio, statutory liquidity ratio, open market operations, monetary transmission, external benchmark lending rate, policy stance, fiscal dominance, anchoring expectations.
• Previous year questions: Practise the previous year questions on this topic →
• Use in an answer:
  • Introduction with data: On 7 October 2026 the Monetary Policy Committee raised the repo rate by 25 basis points to 5.50 per cent and moved to a stance of calibrated tightening, after CPI inflation had risen from 2.75 per cent in January to 4.8 per cent in August 2026.
  • Introduction with a law: Since the Finance Act 2016 amended the RBI Act, monetary policy has had a statutory goal of price stability, with a CPI target of 4 per cent and a band of 2 to 6 per cent set every five years by the government.
  • Conclusion: Inflation targeting has given India lower and more predictable inflation, but it works best when transmission is quick and fiscal and supply side policy pull in the same direction.
  • Conclusion: A central bank's real asset is credibility, and the Monetary Policy Committee keeps it by acting on a clear rule and explaining every decision.