Rupee Pressure Rewrites RBI’s Policy Playbook

The April MPC meeting was set against a precarious backdrop, just ahead of the deadline set by US President Trump for Iran. The ceasefire provided temporary relief, allowing the MPC to retain the status quo on policy rates and stance.

What stood out, however, was the projection of a relatively strong GDP estimate at 6.9% for 2026–27 and the introduction of a core CPI estimate of 4.4% for 2026–27. While inflation projections were raised and growth lowered, these adjustments were modest relative to the sharp reset in dollar/rupee and oil assumptions.

Both the projections made before the ceasefire and the accompanying language signal upside risks to inflation and downside risks to growth, driven by global developments, including the West Asia conflict and a potentially subpar monsoon, with a normal monsoon still assumed.

For its forecasts, the RBI now assumes a dollar/rupee rate of 94 versus 88 earlier and $85 per barrel for oil in 2026–27, up from $70. Inflation projections were raised only marginally to 4.6% for 2026–27 and 2027–28, while the growth forecasts are lowered by 10–30 basis points in April–June and July–September, leaving full-year growth at 6.9%. Growth is expected to slow further to 6.6% in 2027–28.

Upside risks to inflation stem from persistent supply disruptions and El Niño-driven food price shocks. In an adverse scenario, the RBI, as per its Monetary Policy Report, places 2026–27 CPI inflation at 5%, assuming crude at $95 per barrel. Real GDP growth is estimated at 6.9%, with risks to domestic production from the West Asia crisis offset by government measures, rising capacity utilisation, and healthy balance sheets. In the same adverse scenario, growth could ease to 6.7%.

Even after the ceasefire, Brent crude remains around $95 per barrel. Shipping activity through the Strait of Hormuz is yet to normalise, with traffic effectively paused pending clarity from the Islamic Revolutionary Guard Corps. Normalisation may take time, and damage to production infrastructure suggests that supply restoration could take months. At the same time, IEA stockpiles are likely to be replenished, alongside precautionary restocking by major importers. Brent, therefore, appears to have established a floor of $85–90/bbl for 2026–27, implying an Indian basket cost closer to $95–100/bbl. The balance of risks remains skewed towards higher inflation and weaker growth.

April–June 2026–27 and July–September 2026–27 CPI projections of 4% and 4.4% implicitly assume no increase in pump prices after the election cycle ending on April 29. This appears optimistic. At current Brent levels near $95, diesel under-recoveries are estimated at ₹20 per litre. The introduction of a core CPI estimate at 4.4% is also notable. It raises the possibility that the MPC may use core as a signalling anchor to justify an extended pause, even if headline inflation moves above 5% in October–December 2026–27. The statutory mandate, however, remains headline inflation, suggesting that the core estimate is better viewed as a communication device rather than a shift in the policy objective.

FX Constraint
All of these growth and inflation projections, however, become secondary when viewed through the lens of recent FX dynamics. By setting a dollar/rupee baseline of 94, the RBI is effectively acknowledging sustained capital outflow pressures. Recent FX measures have made offshore carry significantly more expensive, with the carry-to-volatility ratio in six-month offshore markets at a decade high. Elevated carry has translated into higher hedging costs for foreign investors, while onshore constraints, including the inability to freely cancel and rebook hedges, have reduced flexibility.

The sharp rise in hedge costs and NDF-implied yields has altered investor incentives.

Fixed income investors may now find short dollar/rupee NDF positions more attractive than holding domestic bonds, even when extending down the credit curve.

Offshore hedging dominates FPI flows, and when hedge positions themselves generate gains, investors have been observed selling one- to one-and-a-half-year AAA NBFC paper, pushing up one- to three-year corporate bond yields. A similar pattern is visible in equities. Combined FPI outflows for March 2026 and April month-to-date stand at approximately ₹1.8 trillion, compared with cumulative inflows of ₹1 trillion across calendar years 2024 and 2025.

At this pace, FX management requires both interest-rate defence and supplementary tools, such as FCNR deposits. Experience from 2013 suggests that FCNR mobilisation typically follows rate hikes. On a standalone basis, FCNR deposits are unlikely to attract flows at current interest differentials unless supported by implicit or explicit subsidies from the central bank.

Policy Response
If capital outflows persist, the RBI may be compelled to moderate domestic demand to contain the current account deficit as balance-of-payments pressures intensify. Unlike the government, which may defer fuel price adjustments until after elections, the central bank does not have that latitude. Market rates have already moved ahead of the policy rate, as evidenced by one-year CD yields, one- to three-year corporate bond yields, and the 10-year government bond yield. In this context, the 6.9% growth projection for 2026–27 reads as implicitly hawkish, providing room for rate hikes without materially compromising growth.

With US core PCE inflation for calendar year 2026 likely to be around 3.1%, the US Federal Reserve may remain on hold, while the European Central Bank and the Bank of England retain a tightening bias. This external backdrop could sustain capital outflow pressures, reinforcing the case for policy tightening. From a real rate perspective, with headline CPI at 4.6%, the policy repo rate may need to move towards 5.75–6%.

2026–27 may therefore see cumulative rate hikes of around 50 basis points, likely in the second half once there is clearer visibility on the monsoon and crude oil trajectory. The 10-year government bond yield may trade in a 6.85–7.25% range in the first half, shifting to 7–7.5% in the second half.

In effect, growth and inflation dynamics may no longer be the primary anchors of monetary policy in the near term. The rupee, and the external vulnerabilities it reflects, are emerging as the dominant constraint on policy. Rate hikes may begin from October, while liquidity tightening, potentially via a CRR increase, remains a near-term possibility, especially as long-term VRRR operations continue to find limited traction with banks. banks. Interestingly, while the Governor’s language indicated the provision of sufficient liquidity, a study on the optimal level suggests liquidity in the 0.6–1.1% of NDTL range, signalling a subtle recalibration away from earlier assumptions of a persistent surplus closer to 1%.