Policy Denial Meets OIS Pricing in India’s Inflation Reality

In Great Expectations, Charles Dickens explores themes of self-realisation and difficult choices. The ongoing Middle East conflict has begun to pose a similar test for emerging market central banks, particularly in India, where policy trade-offs are becoming harder to defer. 

For nearly two months, policymakers have relied on a degree of optimism, and at times hope, as a strategy. Yet the underlying reality is tightening supply across crude, fuel derivatives, fertilisers and key industrial inputs. Benchmark prices signal the stress, with Brent crude at $112 per barrel, urea near $700 per tonne, and natural gas around €46 per MWh. These quoted prices, however, understate conditions in physical markets, where securing supplies has become more difficult amid disrupted trade routes, elevated insurance premiums, and higher logistics costs. Across the energy complex, prices have risen by roughly 50–60% over the past two months, pointing to a supply shock that is already embedded in input costs.

Whether these price increases prove transient is increasingly doubtful. 

Even if the Strait of Hormuz were to reopen fully, rebuilding supply chains will take time, while a renewed emphasis on energy security across countries is likely to keep a higher floor under commodity prices than in the pre-conflict period. 

Bond markets have already moved ahead of policy in recognising this shift, with the OIS curves pricing in overnight fixings at close to 100 basis points of tightening over the next year, beginning with a 25-basis-point move by June and cumulatively implying a policy rate of around 6.25% by April 2027.

The latest MPC minutes, in contrast, appeared largely detached from these expectations, with references to rigid wage dynamics used to support the view that second-round inflation effects remain limited in an economy such as India. 

Governor Sanjay Malhotra’s remarks at Princeton, delivered after the MPC minutes were drafted but just ahead of their publication, offered a more grounded articulation of the challenge.

Malhotra noted that under conditions of uncertainty, delayed or overly gradual responses can complicate the task of managing inflation expectations, making credible anchoring through forward guidance and policy signalling essential. The explicit invocation of the Brainard principle also underscored the dilemma, suggesting a preference for calibrated action even as the underlying risks are acknowledged.

Inflation expectations in an import-dependent economy such as India are shaped less by wage dynamics, though these too are beginning to show signs of pressure, as recent developments in Haryana suggest, and more by the transmission of higher input costs into manufacturing prices. Corporate commentary through the January–March of 2025–26 has consistently pointed to rising input costs and an emerging need for price increases. This is already visible across sectors such as paints, chemicals, milk, chips, mobile phones, electronic items, and packaged foods, as well as automobiles and two-wheelers, indicating that cost pressures are steadily working their way through the system.

By preventing fuel prices from adjusting to higher import costs, policy is effectively suppressing demand adjustment and preserving a temporary equilibrium at the expense of oil marketing company balance sheets, the government’s fiscal position and the rupee exchange rate. The persistence of rupee depreciation, despite recent measures by the Reserve Bank of India, suggests that the exchange rate has become the primary shock absorber in the absence of price pass-through. This, in turn, risks feeding back into inflation expectations over time rather than containing them.

The strong likelihood of an El Niño event this monsoon adds another layer to the inflation outlook. Historical patterns suggest that such episodes are often associated with deficient rainfall, with output contracting by around 2.6% during 2015–16 compared with average growth of 4.4% in the subsequent five years of more favourable monsoons.

The latest projections from the India Meteorological Department are less reassuring than headline interpretations suggest. While the mean rainfall forecast for 2026 is placed at 92% of the long-period average, within the ‘below normal’ range, the probability distribution is more concerning. The likelihood of deficient rainfall, defined as less than 90% of the long-period average, stands at 35%, higher than the 31% probability assigned to the broader ‘below normal’ category. This skew in the distribution implies that the most probable outcome lies closer to a shortfall, increasing the risk that weather-related supply disruptions will compound existing price pressures.

For a net energy-importing economy such as India, suppressing fuel price pass-through creates simultaneous pressure on the fiscal and current account. The balance of payments in 2026–27 is expected to record a deficit of around $40 billion, marking a third consecutive year of external imbalance. Import cover, measured across goods and services, is projected to moderate to about 7.5 months from 8.4 months in 2025–26, still above the 6–7 month range seen during 2013–14 but moving in an unfavourable direction. More concerning is the shift in the composition of external liabilities, with the share of short-term debt, defined by residual maturity of less than one year, rising to 43.2% as of December 2025 from 25.9% in March 2014, increasing rollover and liquidity risks.

The policy implication is increasingly difficult to avoid. Shielding aggregate demand by holding fuel prices unchanged while maintaining a neutral forward guidance stance amounts to deferring adjustment rather than managing it. The current supply shock is likely to feed into inflation expectations over time, and relying on optimism as a policy substitute risks eroding monetary credibility.

While the inflation impulse is clearly supply-driven, it would be optimistic to assume that expectations can remain anchored without some sacrifice in growth. With consumer price inflation for 2026–27 now expected at around 4.9–5%, real policy rates appear compressed relative to underlying risks. Against a potential growth rate of about 7% and expected output growth of 6.8%, a more explicit trade-off may be required, with tighter financial conditions needed to re-anchor inflation expectations.

The divergence between policy positioning and market pricing is therefore becoming harder to sustain. The OIS curve is not merely a forecast; it is a real-time aggregation of expectations around inflation, liquidity and policy credibility. Ignoring that signal risks allowing the adjustment to occur through more disruptive channels, including the exchange rate and term premia. It would be more prudent for policymakers to converge towards the signal embedded in swap markets, rather than resist it, allowing for a more orderly recalibration of rates, expectations and financial conditions.