While the repo rate rise was warranted and widely expected in the Octobermonetary policy, the change in stance to ‘calibrated tightening’ was a surprise. It has been clarified as only ruling out a rate cut in the near future, even as policy will continue to be data-based. To the markets, it confirms their view of the start of a rate-hiking cycle. But what if there is a crash in oil prices and inflation or in growth? 

Being data-based implies keeping all options open.

Given current extreme uncertainty, it is better not to tie one’s hands. In the era of multiple crises, central banks worldwide have become more cautious in giving forward guidance on their rate decisions, while emerging market central banks, which often have to deal with shocks large in relation to their economies, tend to avoid committing themselves.

Advanced economies used forward guidance intensively during the era of repo rates near the zero lower bound. Time-dependent guidance was an additional tool when the rate cut option was limited. But emerging market repo rates are far from zero.

Inflation targeting is inherently forward-looking.

Reacting to expected future macroeconomic conditions reduces the lag in monetary policy impact. If market actions are based on expected future conditions, the required adjustment starts faster, and the central bank can achieve its objectives while doing less. Then why avoid forward guidance on repo rates?

If a central bank has publicly committed to an action for a period of time and conditions change, it will lose credibility if it acts contrary to its announcement. It may, therefore, be forced to avoid making required adjustments.

Central banks do guide markets through forecasts of inflation and growth, but these have error bands and policy has the freedom to adjust if realised values deviate widely from forecasts.

Clear communication of the central bank's reaction function can give markets a good sense of how the central bank will react to evolving macroeconomic conditions and incoming data. This amounts to indirect state- or data-dependent forward guidance that can help achieve central bank objectives without the overcommitment time-based forward guidance entails.

Broader Forward Guidance
The literature largely discusses forward guidance in the context of future repo rate paths responding to objectives of inflation and employment or growth. In canonical inflation targeting, the exchange rate is a fully floating rate; the repo rate does not respond to it.

In emerging markets, however, the exchange rate can overshoot in response to changes in global risk. But the repo rate must not be tied to the exchange rate. So all emerging market central banks hold foreign exchange reserves, intervene and use other prudential instruments to lean against self-fulfilling prophecies leading to persistent real misalignments.

In India, foreign investors overreact to international oil price hikes based on past episodes. And multiple domestic analysts expect repo rates to be raised in line with US rates to keep foreign investors invested in India. But falling domestic growth discourages foreign portfolio investment in equities. For debt flows, growth and currency stability are more important than interest rate differentials. And their market share is still low. As Indian macroeconomic stability rises and that in the US falls, historical interest spreads can be a poor guide.

The underlying theoretical rationale for forward guidance is multiple equilibria. The change from the ‘mumble so as not to be understood’ Greenspan era to the deliberate market guidance under Bernanke came about because of the understanding that markets can otherwise be trapped in less-than-optimal outcomes.

More frequent shocks make interest rate forward guidance different in emerging markets, and more frequent multiple equilibria in financial markets create a need for broader guidance.

Guiding Markets to Better Outcomes
Emerging markets require much more communication about the role of the exchange rate in the central bank reaction function. But there is little guidance on this from the literature, just as there is little research on malaria in Western-dominated medicine.

Moreover, multiple instruments make communication more difficult. Central banks prefer being inscrutable because they do not want to commit to positions or values they may not be able to defend against markets.

But a central bank has the advantage of being able to take a longer view than markets that tend to be fear-driven in volatile times. While precisely estimating equilibrium real interest and exchange rates is difficult, large deviations, such as the current over-depreciation in the Indian real effective exchange rate, can be easily identified. Inflation will follow and result in real appreciation unless domestic interest rates rise enough to severely reduce domestic demand. Such demand switching is not wise in an unstable global environment. Free trade agreements and logistics reform are better bets to raise exports and reduce already low external financing needs.

Committing not to cut rates supports nervous views that Indian rates must follow global rates to woo foreign investors irrespective of the domestic cycle, against the so far successful sheltering of the economy from external shocks.

Hawkish rate guidance accompanying a double rate cut in June 2025 raised 10-year government bond yields, and even more hawkish rate guidance accompanying the current rise will do so again.

When the governor says clearly that the rupee is undervalued, and the Reserve Bank of India will act to prevent persistent misalignment, however, it is good forward guidance.

Since there is no commitment to a specific nominal rate, there is no need to go against markets, for example, when the US Dollar Index is appreciating.

But intervention has to be strategic, drawing on past experience, successes and market intelligence. Spot dollar sales can reduce excess liquidity as well, without raising long-term rates as government bond sales are doing. Sell-buy swaps are said to be raising forward premia. Expected appreciation will reduce hedging costs.

After a brief respite, the two hundreds that panic markets have come together again, oil prices above $100 a barrel and the nominal exchange rate inching towards ₹100 to the dollar. But real oil prices are actually below $50 a barrel.

High oil prices are not sustainable given widespread green substitution. Foreign investors often react to simple red flags. Their information on falling energy intensity and reducing vulnerability to oil shocks is thin. But in volatile conditions, more attention is paid to what central banks say. Clear communication and confident, thoughtful action may help calm overreaction.