Middle East Tensions Pose Global Economic Risk, But RBI Expected to Maintain Status Quo

Monetary Policy Committee Faces Unprecedented Challenges Amid West Asia Crisis

The Monetary Policy Committee (MPC) is set to meet in April to assess the Indian economy's trajectory, which has undergone significant changes since the last policy announcement in February. At that time, geopolitical risks were highlighted, but no macro projections accounted for a West Asia war and its impact on supply chains, commodity prices, and currency markets.

In February, underlying inflation was assessed to be low, despite MPC members considering volatility in energy prices, adverse weather events, and unfavorable base effects from the previous year's large decline in prices. The MPC projected inflation at around 4 percent for the first couple of quarters in FY27, with economic activity remaining resilient despite a challenging external environment. The First Advance Estimate also suggested a continuing robust growth momentum, driven by domestic factors, including robust private consumption demand.

However, since the last policy announcement, geopolitical tensions have escalated dramatically, leading to a significant change in the macro-economic assessment of the Indian economy. The "goldilocks" scenario of high growth and low inflation is likely to alter, with growth expected to move lower while there are risks for inflation to move higher.

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Table: Comparison of Growth and Inflation Projections

The escalation of the US-Israel war has led to the closure of the Strait of Hormuz, which is likely to adversely affect India's exports. The global slowdown will further weigh on external demand, while domestic production lines can be impacted due to supply chain disruptions and high input costs may lead to manufacturers passing them on to end-users.

The government has opened the fiscal purse strings to absorb the pressures from the oil shock, reducing the excise duty on petrol and diesel to keep pump-head prices in check. The government is also likely to absorb the higher subsidy requirements of fertilizer and LPG within the fiscal, protecting the economy from inflation. However, inflation pressures will be felt due to currency depreciation, with the RBI calculating that a 5 percent depreciation leads to a Headline CPI increase of 30-35 bps.

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The critical pressure is on the external sector dynamics, with the share of Gulf countries in India's remittances in FY24 at around 38%. This flow can weaken, leading to a rise in the import bill and a widening of the Current Account Deficit (CAD) to around 1.6-2 percent, dependent on oil prices being in a range of $75-85 a barrel. Capital outflows have been significant in FY26, and with the war conditions, it is unlikely that capital inflows will come in. The USD/INR had depreciated to close to 95 levels before RBI's measures to kill speculation between the deliverable and the non-deliverable markets pulled it back to around the 93 levels.

Given the above, the challenges of monetary policy making have become a tight rope walk for the RBI. The RBI will have to closely look at the inflation dynamics versus the growth perceptions to take a calculated step. The RBI is in an impossible trinity – where a country cannot simultaneously achieve a fixed exchange rate, free capital flow, and an independent monetary policy. In this context, the credibility of the RBI could be towards maintaining an independent monetary policy.

Thus, there is no further scope for policy easing, especially as the globe has started to report inflation challenges emerging out of elevated energy prices. The synchronous easing of monetary policy of 2025 has been replaced by tentative talks of tightening. Even as India would not follow global policy to determine domestic monetary policy, this becomes important as global yields get pushed higher and foreign flows into India can falter.

The April policy is likely to be a status quo policy, with the stance expected to stay unchanged. Fortunately, India has strong growth and a low inflation mix now, there is some room for flexibility and ease of time for the RBI. Critical in this policy is how the RBI communicates on the evolving risk scenarios, which could provide some clues to the markets about RBI actions in the period ahead. Important would also be the RBI's new projections on growth and inflation, which can also provide some cues to the risks ahead with respect to the growth-inflation mix and hence on how monetary policy would conduct itself.

The critical question facing the RBI is whether it should look through a supply side inflation. Possibly yes for now. However, the RBI may have to react by tightening its monetary policy if inflation expectations show an upside risk. The final word is that the repo rate has floored, and if inflation along with inflation expectations surprise on the higher side, the RBI would be more favorable towards tightening, even at the risk of surrendering growth. Our view is that FY27 could see the repo rate hiked by 25-50 bps if the West Asia crisis continues and oil remains on the boil.