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Informist, Wednesday, May 20, 2026

 

By Aaryan Khanna

 

NEW DELHI – The government's decision to hike retail prices of petrol and diesel has crystallised the bond market's fear that the policy repo rate will trend higher in financial year 2026-27 (Apr-Mar). However, the marginal price increase is not likely to push the Reserve Bank of India's Monetary Policy Committee to raise the repo rate at its next meeting in June, dealers said.

 

Oil marketing companies Friday raised prices of petrol and diesel by INR 3 per litre, the first price increase since the West Asia war, which has led to a surge in crude oil prices. They further increased these by about 90 paise Tuesday. The cumulative rise so far is still lower than the INR 5-20 per litre increase that government bond traders had expected. However, the price hike did immediately lead to a sharp rise in yields on short-term debt instruments, especially those maturing between three months and three years. Investors demanded a higher term premium as the expected pass-through of the fuel price increase to retail inflation made a stronger case for tighter monetary policy, dealers said.

 

"If the crisis eases and normal transit resumes before the policy, RBI may prefer to remain cautious and await further clarity before initiating any action," V.R.C. Reddy, head of treasury at Karur Vysya Bank, said. "However, in the absence of a meaningful resolution, the central bank may use the June policy to signal a shift towards tighter policy conditions."

 

"In my view, August policy appears more appropriate for a potential 25 bps (basis point) rate hike," Reddy said. The most immediate gauge of interest rate expectations shows the broader market shares his view. The one-month overnight indexed swap rate, which captures rate expectations until Jun. 20, Tuesday did not fully reflect a repo rate hike of 25 bps next month, dealers said.

 

In a note Friday, Barclays said that an increase of 15 basis points in CPI inflation from June will be attributable to the approximately 3% rise in retail fuel prices. For FY27, bond traders and economists expect India's CPI inflation to be close to 5.0% rather than the 4.6% projection the RBI gave in April, both above the central bank's target of 4.0%. These assumptions include the second-round effects of the diesel and petrol price increases on input costs as well as the hike in the price of compressed natural gas by INR 3 per kilogram between Friday and Sunday. Most traders expect the prices of petrol and diesel will be raised again in coming weeks to take the total increase to up to INR 20 from pre-war levels, but this depends on how long near-month Brent crude oil futures remain above $100 a barrel. These were around $70 a barrel prior to the war.

 

Bond traders said a key reason that monetary policy does not need to curb inflation even three months after crude prices spiked is because retail fuel prices have not been raised till now. In 2022, prices of petrol and diesel were hiked by INR 10 per litre over 15 days, a month after Russia invaded Ukraine. The resulting rise in CPI inflation from an already high trajectory prompted an off-cycle repo rate hike in May 2022.

 

In 2026, the government has used fiscal buffers and asked oil companies to absorb losses to delay and limit the price hike due to the impact of the West Asia war. Traders also said the government likely avoided price hikes in April to avoid unfavourable headlines in the midst of elections in key states. Consequently, retail inflation in April was 3.48%, lower than the RBI's target.

 

"This sort of hike is not enough for the RBI to justify a complete flip in June from its commentary signalling a wait and watch approach into action," the head of trading at a foreign bank said. "So, the government has bought time by doing a slow roll-out (of fuel price hikes) and the RBI is probably going to respond by also not taking any drastic (monetary policy) tightening measures."

 

Just like in the last cycle of fuel price increase, there is unlikely to be a quick return to lower fuel costs in FY27, dealers said. For one, near-month Brent crude futures are likely to average $85-$90 a barrel in the current financial year even if the Strait of Hormuz opens soon, against the pre-war price of around $70 a barrel. Moreover, the government will prioritise making good under-recoveries of oil marketing companies and also reinstate higher excise duties when crude prices fall, dealers said. This will keep the impact on CPI inflation entrenched until the second half of 2027, they said.

 

In anticipation of the fuel price increase, the market had already priced in over 50 bps of repo rate hikes in FY27 and beyond. Most traders believe the RBI and the government will want demand to slow down to keep price pressures in check as the economy deals with the supply side shock, which may be mitigated through fiscal steps, dealers said. Keeping the policy repo rate at the current 5.25% even as CPI inflation averages 5.0% or more in FY27 would be inflationary, based on the RBI's latest formal assessment. RBI staff had computed that a real interest rate – the nominal repo rate net of inflation – of 1.4-1.9% was neutral for the Indian economy. 

 

While some rate hike expectations have been brought forward due to the government's action, bond traders also attribute the spike in bond yields since Friday to the 10-year US Treasury yield surging to a one-year high above 4.60%. Investors in the world's biggest debt market have factored in a rate hike by the US Federal Open Market Committee by April. Consequently, yields on India's benchmark five- and 10-year government bonds Monday touched 6.98% and 7.14%, respectively, their highest in nearly two years.

 

Some sections of the market consider these yield levels too attractive to ignore and are aggressively buying bonds. The most recent comments by RBI officials, including Governor Sanjay Malhotra, that central banks can look through temporary supply-side shocks on inflation without acting, have given such investors confidence that the RBI may not hike rates, dealers said. Moreover, traders at this time do not expect India's average CPI inflation in FY27 to top the upper end of the RBI's 2-6% tolerance band.

 

"The RBI is likely to look through the supply-side inflation and remain on pause in 2026 even if CPI goes to some historical highs," Ritesh Bhusari, joint general manager and deputy treasury head at South Indian Bank, said. "So I think it's a great opportunity to buy bonds at these levels and there is no sense in selling because your interest accrual will outweigh a 50 bps rise in yields."  End

 

US$1 = INR 96.92

IST, or Indian Standard Time, is five-and-a-half hours ahead of GMT

 

Edited by Avishek Dutta

 

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