RBI Should Wait Before it Tightens Policy

Policymaking faces new challenges in an uncertain world, with continuing questions over the geopolitical situation in West Asia and whether a durable resolution is on the anvil. There has been a ceasefire recently, but sporadic escalations have led to volatility in oil prices as well as financial asset markets.

With the US-Iran crisis still not firmly resolved, it is becoming difficult for central banks to take a clear view on whether the current supply-side shocks and the concomitant inflation pressures are transitory or permanent. Some central banks have already bitten the bullet and raised their policy interest rates, while advanced-economy central banks are perceived by markets to be preparing to do so soon.

India’s monetary policy setting does not directly correlate with what other central banks are doing. Still, global tightening worsens the interest rate gap between India and the US, which could have implications for foreign exchange flows.

The growth-inflation dynamics will be relevant for the Reserve Bank of India in determining its monetary policy course, not only for the upcoming meeting but also for future meetings. As indicated, the principal risk facing central banks is to ascertain whether the current uptrend in inflation is transitory or permanent.

The pass-through from wholesale prices to retail inflation has just started in the form of increases in the pump prices of petrol and diesel. The government has increased petrol prices by around 7.4%, while diesel prices have increased by around 8.4%. This will also have some second-round impact on retail inflation through increases in logistics and transportation costs.

We estimate the direct impact at around 40 basis points, alongside an indirect impact of 25-30 basis points. Commercial liquefied petroleum gas prices have also seen large increases, which are already evident in the price momentum for restaurant services.

The Wholesale Price Index reported a large increase in April, with a sharp rise in manufacturing input costs that is also likely to be gradually passed on to consumers. For now, our model predicts headline consumer price inflation at around 5.0% for 2026-27, with October-December 2026 at 5.6% and January-March 2027 at 4.9%. Added to this are the risks of food inflation due to predictions of a weaker monsoon.

Policy Patience
Growth in 2026-27 may get depressed even as advance indicators remain strong for now. Lower growth could come from slower personal consumption, with inflation eroding real incomes and disrupting discretionary spending. Private investment, which had been witnessing some green shoots, is also likely to pull back due to weakening consumption demand and higher input costs.

The manufacturing sector, especially micro, small and medium enterprises, could slow due to supply disruptions, particularly in sectors that rely on imports, especially oil and oil derivatives. Liquefied petroleum gas shortages and aviation turbine fuel price increases have also affected the restaurant and aviation sectors, respectively. Added to this is the risk to agricultural output from El Niño, which may negatively affect rural demand.

The challenge is what the RBI should protect now. Should it be growth or inflation along with the financial stability of the economy?

From a theoretical perspective, monetary policy has limited scope to address supply-led price shocks, and there may be merit in the RBI looking through the recent price pressures, especially as there is very scant evidence of demand-led price increases. Yet it may not be that simple.

The second-round implications of the supply shock on prices become important, such as price increases leading to higher wage revisions, which in turn lead to further price increases. For the RBI, apart from the actual inflation readings, household inflation expectations would be important to watch to understand whether inflation expectations are getting entrenched in the economy.

Importantly, even before the West Asia crisis had started, RBI surveys of household inflation expectations showed an increase in both the February and April surveys. This needs to be watched carefully.

For now, we expect the RBI to skip June as the starting point of its rate-hiking cycle. While it may be difficult to provide crystal-clear guidance, it may be useful for the RBI to present its assessment of the factors it is watching and what might trigger an eventual rate hike.

For the future trajectory of rates, by the most simplistic logic, if average inflation for 2026-27 is around 5.0%, and a real gap of 1% is built over it, then the policy rate can potentially move up to 6.0%, or 75 basis points higher than the current level of 5.25%.

* Views are personal.