The Reserve Bank of India's (RBI) inflation mandate has likely reinforced the push to drain excess liquidity, with odds of a rate hike at the October Monetary Policy Committee (MPC) meeting now on the rise, according to leading economists. Short-end rates are expected to remain elevated as markets price in potential increases to the benchmark repo rate.

Liquidity Conditions Tighten Sharply

According to Radhika Rao, Senior Economist and Executive Director at DBS Bank, a pullback in benchmark oil prices helped stabilise Indian rupee asset markets, though an overnight climb in US yields may counteract some of that positive effect. She noted that the USD/INR had settled near the mid-95 handle but is poised to resume its upward climb, drawing strong intervention bids.

'Liquidity conditions have tightened meaningfully following the central bank's sustained absorption operations, which have relied on a mix of open market operations, VRRR auctions, and short-tenor sell-buy swaps,' Rao explained. Tax outflows, rising seasonal currency leakage, and intermittent foreign exchange sales further narrowed the surplus.

As a result, the system liquidity balance fell below ₹5 lakh crore last week, down from a peak of approximately ₹10–11 lakh crore. Rao noted that this tightening has helped improve monetary policy transmission and brought the weighted average call rate closer in line with the repo rate. She also highlighted that liquidity and core inflation have historically shared a modest positive relationship.

HSBC Forecasts Two 25 bp Hikes in October and December

Pranjul Bhandari, Chief India Economist and Strategist at HSBC Global Investment Research, said her team maintains a long-held view of two 25 basis point (bp) hikes — one each at the October and December MPC meetings — which would take the repo rate to 5.75%.

'We also expect further clarity and steps on liquidity removal in the October meeting,' Bhandari noted. She cautioned that excess liquidity can quickly turn inflationary and raise financial stability risks, particularly if banks become overly dependent on abundant funding conditions.

RBI Tools Already in Play

The central bank has already deployed a range of instruments to absorb surplus liquidity, including Variable Rate Reverse Repo (VRRR) auctions, Open Market Operation (OMO) sales, and foreign exchange swaps and spot sales. According to economists, Cash Reserve Ratio (CRR) hikes and Market Stabilisation Scheme (MSS) issuance remain under active consideration as additional tools.

What to Watch at the October MPC Meeting

The October MPC meeting is shaping up as a critical policy inflection point. Markets will closely track the RBI's tone on inflation, any further guidance on liquidity normalisation, and whether the rate decision matches the two-hike consensus forming among major forecasters. A decisive move could cement the trajectory for the rest of the financial year and signal how aggressively the RBI intends to anchor inflation expectations.