Oil Shock From Iran Conflict May Test RBI’s Policy Comfort

Escalating geopolitical tensions in West Asia may soon test the Reserve Bank of India’s relatively comfortable inflation outlook. A sharp rise in crude prices and renewed pressure on the rupee could complicate the central bank’s expectation that inflation will remain benign enough to allow interest rates to stay unchanged or even decline over time.

The US-Israeli strikes on Iran represent one of the most serious threats to global energy flows in decades, largely because of the risk of disruption to the Strait of Hormuz. The narrow shipping channel carries roughly 20 million barrels of crude a day and close to 20% of global LNG trade, making it a critical artery for global energy markets.

For energy markets, the duration of the conflict will be critical. Analysts believe global markets could withstand the closure of the strait for one to two weeks, supported by inventories and strategic reserves. Disruptions extending beyond three weeks, however, could trigger a much sharper rise in prices, as alternative export routes lack the capacity to replace lost shipments.

Oil markets have already reacted strongly. Several analysts have raised their 2026 Brent crude assumptions to around $80 per barrel from $65 earlier, while prices briefly jumped to around $120 per barrel following the US-Israeli strikes. Even after some moderation, prices remain roughly 25% above the RBI’s baseline assumption of $70 per barrel cited in its October Monetary Policy Report.

For India, which imports nearly 85% of its crude oil needs, higher oil prices carry significant macroeconomic implications. The RBI’s Monetary Policy Report estimates that a 10% increase in crude prices above the baseline could raise inflation by around 30 basis points and reduce growth by roughly 15 basis points, assuming full pass-through to domestic prices.

However, those estimates were based on the previous CPI series. Under the new CPI series with a 2024 base year, the weight of the transport and communication category, where fuel costs exert a strong influence, has increased to 12.41% from 8.59%. This suggests oil shocks may transmit somewhat more strongly into headline inflation than earlier RBI estimates implied.

Currency movements are adding to the pressure. The rupee is trading above ₹92 per dollar, about 5% weaker than the RBI’s baseline assumption of ₹88. The central bank estimates that a 5% depreciation could lift inflation by roughly 35 basis points, highlighting how exchange-rate movements can amplify imported price pressures.

Together, elevated oil prices and a weaker rupee raise the risk of imported inflation even as they weigh on domestic demand and investment conditions.

Just last week, RBI Governor Sanjay Malhotra suggested the policy rate could remain at current levels, or even move lower, for an extended period, citing benign inflation and subdued underlying price pressures. “We expect the policy rate to be at the current level or lower for a long time, barring any shocks,” he said.  

The surge in commodity prices following the escalation of tensions in West Asia may represent precisely such a shock.

The RBI currently projects headline inflation at 4.0% for the April–June quarter and 4.2% for the July–September quarter. If crude prices remain elevated for a sustained period, inflation could drift closer to the upper end of the central bank’s 2–6% tolerance band during 2026–27.

Even so, the Monetary Policy Committee is unlikely to react immediately through tighter policy. Policymakers will first assess whether the oil shock proves temporary or begins feeding into inflation expectations and core price pressures.

Instead, the policy statement may initially emphasise vigilance rather than action, acknowledging emerging inflation risks while retaining the current stance and signalling that the RBI is closely monitoring the evolving global situation.

Financial market stability will also remain a priority. The RBI may step up intervention in the foreign exchange market to limit excessive rupee volatility. Such actions typically withdraw liquidity from the banking system, potentially tightening financial conditions. To offset this effect, the central bank may conduct open market operations to inject liquidity.

Beyond oil itself, disruptions in the Gulf could also affect fertiliser inputs and certain industrial metals, potentially feeding into global manufacturing costs and food inflation.

If the current West Asia conflict turns into a prolonged disruption to energy markets, India’s policy calculus could shift accordingly. The RBI’s current comfort with stable or lower interest rates rests heavily on the assumption that inflation pressures will remain contained. A sustained oil shock, combined with currency weakness, could quickly narrow the room for policy accommodation.