Not Out of the Woods Yet

Many analysts expect the Reserve Bank of India to hold its policy repo rate for an extended period. Yet the balance of risks is shifting. 

Financial markets are already pricing several rate hikes over the next 12 months — which may seem somewhat aggressive at this stage but is not entirely misplaced. Even if immediate tightening is not on the cards, risks are rising that sticky inflation pressures could emerge with a lag, eventually demanding policy action.

The Monetary Policy Committee’s recent decision to hold the repo rate steady came at a fortuitous moment. It coincided with the announcement of a ceasefire in the Middle East, easing acute energy market stress. Crude prices softened, the dollar weakened, and risk assets rallied. For policymakers, this provided a timely breather.

That pause, however, should not be confused with resolution. Energy prices remain central to India’s inflation, growth, and external balance dynamics. While the ceasefire has reduced near‑term volatility, it does little to eliminate deeper risks emanating from energy sector disruptions. Against this backdrop, the MPC’s wait‑and‑watch stance reflected caution, not confidence.

The Reserve Bank of India’s baseline forecasts underscore this fragility. They assume an average crude oil price of $85 per barrel in 2026-27 and a dollar/rupee level of 94/$1. On these assumptions, Consumer Price Index inflation is projected at 4.6%, following an ‘A‑shaped’ trajectory that peaks above 5% by late 2026 before easing modestly. Even more tellingly, the Monetary Policy Report notes inflation would still average 4.6% in 2027-28 if crude prices fell to $75 per barrel. This points to persistence rather than transience.

The larger risk lies in oil prices staying above these assumptions. For near‑term calm, the ceasefire must hold. But for a durable moderation in energy prices, regional tensions in the Middle East must ease enough to normalise supply chains and shipping through the Strait of Hormuz. Even then, restoring production to capacity will take time and stockpiling will keep energy prices elevated for longer.

The RBI’s stress scenarios illustrate what is at stake. If the oil price is $10 per barrel higher than assumed for 2026-27 and 2027-28, CPI inflation would rise to about 5% and 5.1%, respectively. That deviation from the baseline may appear modest, but for monetary policy credibility, it is significant.

India’s flexible inflation targeting framework allows temporary overshoots. The MPC can tolerate inflation above 4% if it expects inflation to ease back to target within the forecast horizon. But if the crude price settles in a $90–100 range, inflation may drift up instead of returning along the assumed path. In that scenario, continued inaction would carry growing risks of policy error.

Beyond model projections, inflation transmission dynamics deserve attention. Policymakers typically look through first‑round energy price shocks because oil price shocks are stagflationary, thus requiring patience. The policy challenge intensifies when second‑round effects appear and gather weight. That is when inflation becomes broader and more persistent.

Second‑round effects matter because they shape expectations. Once households anticipate sustained price pressures, monetary policy flexibility narrows. India is especially vulnerable here, given the dominant influence of food and transport prices on household inflation expectations.

So far, consumers have been somewhat protected from higher oil prices by oil marketing companies reducing their margins and the government cutting excise on petrol and diesel. But these buffers cannot last indefinitely. If elevated prices persist, pump prices will rise, triggering visible pass‑through to consumers and reviving inflation momentum.

Food inflation is a subtler but formidable risk. Elevated agricultural input costs typically feed into food prices with a lag of three to four quarters, varying across items and complicating forecasts. Fertiliser subsidies delay and blunt this transmission but do not eliminate it. As a result, risks accumulate almost invisibly before materialising. Our research suggests input-cost inflation plays a larger role in shaping food price trends than weather shocks alone.

That said, weather risks can amplify pressures this year. A rising probability of El Nino and its impact on the southwest monsoon adds uncertainty to the food price outlook. History shows that a single adverse food inflation print can upend the outlook, as seen during the tomato price shock of 2023.

Core inflation may not remain as benign as it currently is. Input costs across sectors are rising, as purchasing managers’ surveys indicated for March. Firms have so far absorbed these pressures through poorer profit margins, but that strategy has limits. Over time, costs spill into consumer prices.

Once inflation becomes broad based, policy choices become harder. Credibility considerations emerge even if headline inflation remains below the upper tolerance limit of 6%. If inflation stays stuck above 5% for several quarters, anchoring expectations becomes important.

The nature of the current energy shock complicates matters, as it is both a terms‑of‑trade shock and a real supply shock, weighing on growth and inflation in a non‑linear way. As long as supply disruptions dominate, trade‑offs remain delicate. But if supply conditions ease, while import costs remain high, inflation concerns will dominate policy decisions.

The RBI’s projections suggest the impact of a higher oil price on growth under various scenarios is relatively modest, compared to the cost of higher inflation. Even in stress scenarios, growth could remain around 6.5%. That perhaps gives policymakers room to prioritise inflation control in future, if needed. Markets appear to be recognising this asymmetry.

The prevailing expectation of an extended policy hold may still prove correct. But the range of risks suggests the odds of a delayed inflation hit and policy response are rising. In such an environment, vigilance matters more than comfort. These are risks policymakers and markets cannot afford to ignore.