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Summary
India’s Reserve Bank and government have been pushed by the Gulf war into no-win situations on multiple fronts. Inflation, growth, exchange rate, budget allocations and other variables have all been unsettled. Can a grand rebalance be attained?
Policy formulation will see challenges mount in 2026-27 as the effects of the West Asia war unsettle India’s growth picture. The high price of oil has exposed its vulnerability, with the reverberations of every policy action or non-action likely to influence other parts of the economy.
Let’s start with monetary policy first. The regime of low interest rates is over and the decision that India’s central bank must take is when—and by how much—to raise its repo rate. The Goldilocks scenario has turned into a Cinderella syndrome, where all base effects turn negative and inflation pushes aggressively upwards.
This is a global phenomenon. Last year, India managed to counter the US tariff blitzkrieg well. But this year’s oil crisis differs; it resembles episodes of the 1970s when the shock was felt across almost every sphere.
Inflation will hurt on two fronts. The first is through crude oil prices.
India’s state-run retailers have had to hike the retail prices of fuel, particularly of compressed natural gas, petrol and diesel. Liquefied petroleum gas and aviation turbine fuel prices were hiked earlier.
More hikes are expected to follow over time, as only a part of the increased cost burden of oil marketing companies (OMCs) has been covered so far. Therefore, fuel-induced inflation will have secondary effects, with transport costs likely to rise by 3-3.5%, triggering a tertiary round once companies start increasing prices. Wholesale price index data for April shows an over 8% spike in producer level prices, which will feed into retail prices through the supply chain route.
The government has also raised import duties on precious metals and put curbs on the import of silver. While this could slow inward shipments, a black market could develop. This may seem irrelevant to monetary policy, but even if demand for these metals weakens, given their weight in India’s consumer price index, we can expect upward pressure on retail prices.
Next, look at agriculture. The government has announced an increase of an average 5% in minimum support prices (MSPs) for kharif crops over last year’s rates. This was timely from the perspective of farmers; with the India Meteorological Department and Skymet predicting a sub-normal monsoon amid an El Niño possibility, there are concerns of crop prospects being impacted. But raised MSPs are likely to lead benchmark market prices up. This means that even if we experience normal rainfall and farm supplies do not decline, prices will rise.
Last, the rupee has been depreciating on account of a widening trade balance and relentless withdrawals of funds by foreign portfolio investors. A stronger dollar has played a role too. Rapid rupee depreciation means that every item imported is shipped in at a higher price, affecting everything from mandarins to electronic components.
Putting all these factors together, inflation is set to climb on last year’s low base. This means that the central bank’s Monetary Policy Committee (MPC) cannot term the price upshoot ‘transitory’ for policymakers to ‘see through.’ The overnight index swaps market indicates that this year might see up to two repo rate hikes. The question, however, is how the MPC views these factors.
Higher inflation also has the potential to come in the way of consumption, which was nudged upwards by last year’s tax breaks. In the worst-case scenario of lower farm output due to a sub-normal monsoon and higher oil-induced inflation, both urban and rural demand could be affected. Therefore, GDP growth will be under watch.
The MPC has to balance concerns around lower growth with possible higher cost-push inflation while determining its policy rate trajectory. This is not easy, as there are strong arguments for both a pause and an aggressive hike. The MPC also has to consider bond yields, which are stubbornly on the rise. One reason for this is the market concern over government borrowing.
Fiscal management will be no easier. On the revenue side, the government has lowered excise duty on fuel products, which can cause a hit of ₹1.2-1.4 trillion if it is not reversed during the year. Corporate tax collections from OMCs will be nil, as there are no profits to be made, which will mean zero OMC dividends for the Centre; these were above ₹70,000 crore in 2024-25.
The fertilizer subsidy bill will also increase and could exceed the budget outlay by at least 20%—or about ₹30-35,000 crore. The Reserve Bank of India’s surplus transfer, though, could rise from ₹2.7 trillion last year to ₹3.2 trillion. This can offer the 2026-27 budget only a partial buffer, though.
The conundrum for the government is whether or not to go through with its discretionary capex, given that social outlays cannot be lowered at a time like this. But then, letting the deficit slip by up to half a percentage point may not be a bad thing, given the scale of this crisis.
In parallel, exchange-rate management will require heightened attention; a balance will need to be struck between the ill effects of rapid rupee depreciation, which could become self-fulfilling, and letting a weaker currency aid exports. The adverse effects include imported inflation.
Similarly, any import tariff hikes would worsen price instability, complicating India’s monetary policy challenge. The government will need to let fuel prices rise, but that is inflationary too. And if RBI raises rates, growth could slow down.
It’s a circular chain, really.
These are the author’s personal views.
The author is chief economist, Bank of Baroda, and author of ‘Corporate Quirks: The Darker Side of the Sun’
English (US) ·