Repeated supply shocks strengthen the case for reconsidering India’s 4% inflation target, but do not remove the need for further interest rate increases to protect savers’ real returns, economist Abheek Barua says. The distinction is between adjusting the monetary policy framework to a changed economic environment and managing the immediate consequences of inflation for savings and borrowing.

In an interview with BasisPoint Insight’s Kalyan Ram, Barua argues that a succession of disruptions can keep inflation elevated even when individual shocks are temporary. A shortage of essential inputs can simultaneously raise prices and reduce production, with the output loss spreading through demand for labour, raw materials and working capital. Tightening policy against such price pressures risks weakening activity already constrained by supply.

This leaves the RBI with a difficult choice: accept a somewhat higher inflation trajectory or tighten more aggressively to achieve the existing target. Barua favours considering an adjusted target, warning that the output costs of pursuing 4% could rise when more of the inflation process lies beyond the central bank’s control.

That longer-term argument sits alongside his support for the RBI’s latest 25-basis-point increase and calibrated tightening stance. Further increases could be warranted if inflation settles around 5% or climbs above 5.5%, he says. But calibration should mean examining the forces behind inflation rather than signalling an aggressive tightening cycle. He sees the current Monetary Policy Committee’s caution as recognition of these complications.

Barua also disputes the diagnosis that the rupee’s weakness can be corrected mainly by improving the interest rate differential with the United States. Equity flows are influenced by investment opportunities abroad, including the artificial intelligence trade, and concerns about Indian manufacturing. A narrow focus on carry, he argues, misses the reasons investors are reallocating capital.

He expects the RBI’s latest foreign exchange measures to offer some temporary relief, potentially forcing investors with short rupee positions to unwind them. But that would not establish a durable reversal without a change in underlying flows. His reading is that ₹97 to the dollar has become a level the central bank is seeking to defend, rather than an officially announced objective.

A fall in oil prices could ease pressure. Without renewed appetite for India as an investment destination, however, he expects the RBI’s currency management challenge to persist.

The conversation below has been edited for clarity and length. (Click hear to listen to the full podcast)

Q: You have argued that monetary policy settings need to change. What do you mean by a “permacrisis”, and why does it matter for central banks?

A: Monetary policy, and macroeconomic policy more generally, face a different set of challenges because we are experiencing one supply shock after another. I borrowed the term “permacrisis” from a book by Michael Spence, Mohamed El-Erian and Gordon Brown. Their argument is that a continuing sequence of shocks changes the way economies grow and contract.

The supply side becomes much more important in determining variations in output. These developments also affect the movement of capital. My broader argument is that the old assumptions of monetary policy, which focused largely on demand management, may need to be reconsidered, and the instruments retooled to recognise that supply conditions will remain in flux. The sources of that disruption are not necessarily correlated.

Look at the sequence since COVID. We had the pandemic, followed by the Ukraine war and then the Trump tariffs. We have also had the mass adoption of artificial intelligence, which has contributed to capital outflows. These are different developments, but they illustrate how supply-side changes increasingly influence headline numbers, whether GDP, capital flows or the balance of payments.

That is the point I am making. It has implications for how monetary policy is conducted.

Q: Central banks usually look through the first-round effects of a supply shock and try to contain its second-round impact on inflation. Does a succession of shocks blur that distinction?

A: I think it does. Even if an individual supply shock is temporary, the sheer frequency of shocks can create a persistent influence on the economy. Some shocks are also proving not to be temporary and are becoming entrenched in the system.

Supply shocks are typically associated with inflation. What we may therefore be seeing, globally and in India, is a longer-term upward inflation bias. A central bank cannot really address the first-round effects of a supply shock. But if shocks keep arriving and keep headline inflation elevated, what should it do?

One option is to accept a higher inflation trajectory, or an adjusted inflation target, as a consequence of this fundamental change in the global economy. The other is to insist on achieving the existing central target, which may require more aggressive monetary tightening. That is not necessarily a desirable outcome.

I do not want to jump to a conclusion or offer a ready-made solution. I am identifying a problem that creates a new set of trade-offs and dilemmas for monetary policy. The familiar relationships between output and inflation become less dependable when the supply side is more dominant, more uncertain and constantly changing.

Do we need a new operating paradigm? I believe we at least need to recognise these changes when making monetary policy.

Q: You have argued in your column that an input shortage can reduce a, for instance, telecom manufacturer’s output and, in turn, its demand for labour, raw materials and working capital. How should monetary policy interpret that process?

A: My fundamental argument is that the supply side now has a greater role in determining variations in output.

Take a shortage of rare earths from China. That can affect the telecom or electric vehicle industry, leading to an output contraction in the affected sector. The contraction then filters through to other sectors connected to it.

Because the initial disruption is a supply shock, one of the first things visible in the macroeconomic numbers may be a rise in prices. You can therefore have inflation in telecom equipment at the same time as an output shortfall. There is effectively rationing, and its effects spread to related sectors.

Policymakers need to be careful about interpreting that price increase. Rather than automatically associating higher prices for a mobile handset or other telecom equipment with stronger demand, they need to establish where the pressure is coming from.

Supply conditions increasingly determine whether output contracts or expands. If inflation is accompanied by an output loss, the policy question becomes more complicated. What should monetary policy do in that situation?

That is why I think policy needs to refocus on the role of the supply side in determining economic outcomes.

Q: Does that mean the government should give the RBI greater leeway on inflation targeting? Is a 4% target too conservative in the present environment?

A: I think so. The question is whether the RBI should become a more aggressive inflation fighter in a situation where a greater part of the inflation process is outside its control.

I would argue for considering a somewhat adjusted inflation target instead. The word “permanent” is important here. If supply conditions remain in a state of flux, how much can the central bank do? And does trying to do too much risk throwing the baby out with the bathwater?

That is the view I lean towards. Others would argue that the RBI’s duty is to bring inflation down at any cost. But in the presence of these supply problems, that approach could require more aggressive monetary tightening, which I would regard as undesirable.

Q: Do you support the RBI’s latest 25-basis-point rate increase and the shift to calibrated tightening?

A: Yes. Calibrated tightening is appropriate, but the RBI needs to watch how supply conditions evolve. There are major events ahead, and it should not signal that it is entering an aggressive tightening phase.

The important word is “calibrated”. To me, that signals that the RBI will not get carried away by headline inflation numbers alone. It will examine the processes underlying inflation before deciding what to do next.

Q: Some argue that the RBI should have raised rates earlier. Do the MPC’s discussions suggest that it already recognises the supply-side complications you describe?

A: I think that is right. This is a balanced and prudent MPC. Its members have flagged the complexity of the inflation build-up in their discussions and have not been carried away by developments to which a more hawkish committee might have responded very differently.

But monetary policy is also about signalling and, to some extent, responding to the market. A central bank cannot be seen to be falling behind the curve, because that perception can affect the currency and other markets. It has to strike a balance.

These are related but distinct challenges. One concerns the underlying economic problem; the other concerns managing market expectations. Markets can second-guess a central bank’s commitment to controlling inflation, and questions about its independence can also arise. The RBI and the MPC have to take that into account.

My assessment is that the MPC is doing what is optimal given these challenges. It has recognised the complexity of inflation and has flagged it across successive policy discussions.

Q: The counterargument is that nominal and real interest rates are too low, discouraging savers and risking financial repression. Is that concern valid?

A: I think it is valid to an extent. If inflation climbs above 5.5%, or settles around 5%, we could need a couple of further rate increases to bring real interest rates up.

But these are near-term decisions that must be taken against the backdrop of volatile supply conditions. The longer-term challenge is to manage those conditions without deterring output or allowing it to fall significantly below potential.

Along the way, there will be more immediate problems to address: managing real interest rates and maintaining equilibrium between savings and borrowing. Those decisions still have to be taken.

I do not see an inconsistency between recognising the longer-term supply-side problem and accepting that further rate increases may be warranted to address these immediate concerns.

Q: The rupee came under renewed pressure after the policy decision, with some in the market blaming the RBI for being behind the curve. Would higher interest rates resolve that pressure?

A: I would not necessarily buy that argument. It is a very trader-oriented argument, based on carry and the assumption that getting the differential between US and Indian interest rates right will reverse the flows.

What is happening to the currency is more complex. Equity flows are an important part of the picture, and the factors driving them away from India cannot be reduced to interest rate differentials.

There is the AI innovation trade, which India has missed out on. There are also concerns about local manufacturing, particularly given supply constraints arising from restricted access to inputs from countries such as China.

In a situation of this complexity, a perspective that looks only at carry is limited. It can also be counterproductive if the response is simply to try to support the rupee through higher interest rate differentials.

That approach will not work beyond a point. More fundamentally, I think it rests on an incorrect diagnosis of the problem.

Q: What do you make of the RBI’s latest foreign exchange measures, including the reserve requirement-type measure on hedging and its decision to meet oil companies’ dollar demand directly? How do they fit with the earlier effort to attract large overseas deposits?

A: There have already been outflows that have reduced reserves from the initial build-up. The question is how the RBI responds.

Despite its claims to the contrary, the RBI does defend particular exchange rate levels quite vigorously. We have seen that at ₹95 to the dollar and at lower levels in the past. My reading is that ₹97 now appears to be a line in the sand, and the RBI is trying to find the best way to prevent the rupee from slipping beyond it.

There is often an assumption behind defending a particular level: holding it could trigger a squeeze on those who have taken aggressive short positions, leading to a recovery in the rupee and potentially a more favourable cycle.

Some of that may happen. The reserve requirement-type measure, which is new to the playbook, could help induce such a move. So, yes, these measures can provide short-term relief.

But look at what happened with the FCNR(B) flows. The rupee strengthened to around ₹94 to the dollar and then moved back towards ₹96. Short positions can be closed out and the rupee can appreciate somewhat, but that does not change the underlying fundamentals. I do not presently see those changing, particularly in relation to portfolio flows.

Another source of relief would be oil prices. We need to see how the situation in the Middle East develops. That is itself an example of a supply shock that seems to persist and become more complicated.

Unless there is renewed appetite for India as a destination for capital, which does not appear to be the case at the moment, this is likely to be a long battle for the RBI. How it chooses to fight that battle, and how aggressive it becomes, will be important in determining where the rupee goes over the next few months.