Staying on Pause May Be the Optimal Policy Response to a Supply-Shock

The April policy was the first Monetary Policy Committee meeting after the West Asia crisis. The policy was important from a guidance perspective and also provided the first glimpse of how the Reserve Bank of India viewed the crisis. The pause was expected, as it was too early to react to the crisis. The neutral stance was retained as it allowed the RBI flexibility to respond to both the upside risk to inflation and the downside risk to growth.

The tone of the policy was neutral, with the RBI not going out of its way to rule out rate hikes. This was indicated by the emphasis on both the upside risk to inflation and the downside risk to growth arising from elevated energy prices and supply-side shocks.

RBI’s forecasts showed greater risk to inflation from the West Asia crisis, with 2026-27 CPI inflation revised up to 4.6% and Real GDP growth revised down to 6.9%. The quarterly profile for growth and inflation shows that the crisis first adversely impacts growth in April-September and then adversely impacts inflation in October-March. In the second half of 2026-27, average real GDP growth rises to 7.2% from 6.8% in the first half, while CPI inflation rises to 5.0% in October-March versus 4.2% in April-September. RBI’s forecasts are premised on the Indian crude oil basket averaging $85 a barrel in 2026-27.

Looking at the baseline forecasts for October-March, does this pave the way for rate hikes? Or are we reading too much into it? Forecasting is perilous at the best of times, and even more so during crisis periods. The RBI emphasised this by underscoring risks to its forecasts from second-round impacts of a surge in energy prices and higher food prices, with the possibility of El Niño conditions.

To answer this question, one needs to ask what a rate hike would solve. When the economy is facing a supply shock, hiking policy rates does not resolve the supply issue; it only adds to demand destruction. Moreover, RBI’s estimates indicate that the upward pressure on inflation remains driven by supply-side factors, with a well-behaved core inflation estimate. To provide greater clarity on its thinking, the RBI, for the first time, provided a core CPI inflation estimate for 2026-27 at 4.4%. Excluding gold and silver, core inflation would be even lower. We estimate core-core inflation—excluding gold and silver, and petrol and diesel—to be contained at 3.3% in 2026-27.

In past episodes of supply-side shocks, the RBI has resorted to rate hikes only when CPI inflation has breached the 6% mark for a few months. This was seen during the Russia–Ukraine escalation, when crude oil prices averaged $93 per barrel in 2022-23. The rate hikes started after headline CPI inflation remained above 6% for a few months. Real GDP growth was 7.6% in 2022-23, which also included some catch-up recovery from the Covid-19 shock. In the current context, RBI’s inflation estimates indicate that headline CPI inflation does not exceed the upper threshold of the inflation target band of 6%. Our inflation estimate is higher than the RBI’s at 4.9% in 2026-27, but it also does not exceed the upper threshold.

A key factor supporting the RBI staying on pause is the downside risk to growth, as the duration of the crisis is unknown. The longer the Strait of Hormuz remains closed, the more pronounced the supply-side disruptions will be. The Russia–Ukraine period involved only a price shock, whereas the West Asia crisis has twin components of price and quantity disruptions. RBI’s estimate of 6.9% real GDP growth in 2026-27 would hold if the supply shock remains confined to April-June. If disruptions persist into July-September, real GDP growth could be around 6.5% or lower.

Given the degree of uncertainty and the unprecedented nature of the shock, the best response from monetary policy would be to remain on pause and ensure liquidity remains ample. Fiscal policy will need to be the first line of defense, as it is better suited to deal with supply-side shocks. The Government of India has already initiated measures to shield consumers from elevated energy prices,