RBI policy suggests growth risks may outweigh inflation risks; MPC likely to maintain prolonged pause

The RBI Monetary Policy decision - status quo on policy rates as well as neutral stance - came on expected lines; however, unlike previous policies where the discussions and decisions were centered more around impact of trade tariffs, a noticeable change in the MPC’s narrative this time was the dominance of the US-Iran conflict and its evolving impact on the economy.

The RBI Governor spelt out at length the global geo-political situation and its probable impact on the Indian economy, in terms of (1) elevated crude oil prices could increase imported inflation and widen the current account deficit, (2) disruptions in energy and commodity markets may adversely impact domestic output, (3) heightened uncertainty, increased risk aversion and safe haven demand could impact domestic liquidity conditions, economic activity, consumption and investment, (4) weaker global growth prospects may dampen external demand and reduce remittance flows; and (5) adverse spillovers from global financial markets could tighten domestic financial conditions and raise the cost of borrowing. The current supply shock could potentially spillover to a demand shock if the supply chains are not restored soon.

Having spelt out the risks upfront, the RBI Governor however provided comfort in terms of the Indian economy’s fundamentals being on a solid footing, and the economy’s resilience to withstand shocks being much higher than in previous instances. There are a number of positives for growth - sustained momentum in services sector, GST rationalization and healthy balance sheets of the corporate sector will support economic activity.

High frequency indicators are supportive, business expectations are (still) optimistic, reservoir levels are healthy and the Government’s focus on manufacturing augurs well for growth. Discretionary spending is healthy and supporting private consumption, rural demand is robust while urban demand is improving.

However, elevated energy and other commodity prices, along with supply disruptions in the Strait of Hormuz, will likely adversely impact growth in FY 2026-27. Exports are likely to be affected on account of the US-Iran conflict and the impasse at the Strait of Hormuz.

Accordingly, there has been a substantial downward revision to GDP growth, with FY27 projected at 6.9%, compared to 7.6% (expected) growth in FY26.

On the inflation front, the CPI has so far been well below target (2.7% in January in 3.2% in February). Core inflation at 3.7% has also been moderate. However, the inflation outlook will be clouded on account of the war situation, with high energy prices and supply shocks emerging as key risks, despite the Government ensuring steady retail prices of petrol and diesel. While food prices, buffer stocks and reservoir levels are all at comfortable levels, the likely onset of El Nino could pose a risk.

The CPI for FY27 is projected higher at 4.6% (compared to projection of 2.1% for FY26), with the global situation adversely impacting the Indian economy in Q3/Q4, rising to a high of 5.2% (projected). The RBI has, for the first time, given its projection for Core inflation, at 4.4% for FY27, which is reasonable, and which would have been far lower if precious metals were excluded.

There was not much reference to liquidity measures in the policy speech (unlike in previous policies). While yields across the board have moved up since March on account of high energy prices as well as rising global yields, the domestic liquidity situation has been so far well managed, with the RBI carrying out durable as well as transient liquidity measures. The RBI is committed to proactively and pre-emptively managing liquidity and ensuring sufficient liquidity in the banking system.

The external sector has been witnessing some disruption for some time, initially on account of the trade tariffs and now due to the war situation and the blockade at the Strait of Hormuz. Overall, India’s merchandise exports have been adversely impacted while imports have risen largely due to rise in gold imports, which has led to a rise in the trade deficit. The higher energy prices and the global uncertainties pose an upside risk to India’s Current Account Deficit.

In light of the recent depreciation of the INR, the Governor reiterated that the RBI’s stance with respect to the Rupee remains unchanged. RBI’s periodic interventions in the forex markets are aimed at smoothening the INR’s course and preventing excessive volatility; the RBI does not target any trading band for the INR and would rather let the value of the INR be determined by market forces.

Looking ahead

The MPC has adequately highlighted the risks to growth and inflation emanating from the war situation and the accompanying rise in energy prices as well as the supply shocks. This is reflected in the MPC’s meaningful downward projection of growth and upward projection of inflation. The MPC will have to carefully weigh the evolving growth-inflation dynamics and accordingly fine-tune its policy outlook as well as liquidity management.

Markets had already reconciled, ahead of the war, to the likelihood that the rate-cut cycle is over; the emergence of the war and the ensuing shocks were additionally creating concerns whether the MPC would bite the bullet and carry out a rate hike later in the year. However, the current RBI policy suggests that, on the balance, the risks to growth may out-weigh the risks to inflation, which may in turn suggest that the MPC may just prefer an elongated pause through the year.

Fixed income yields had moved up sharply since the out-break of the war, reflecting the concerns around energy prices, supply shocks and the global yield situation. The very recent temporary ceasefire announced brings some relief to both the fixed income and equity markets (which were seeing regular outflows).

If the ceasefire results in a more durable peace accord, fixed income and equity markets should both benefit and revert to more reasonable levels and help improve investor sentiment (domestic and global). However, the variables that will continue to weigh on Indian markets will be the oil prices (at what level they sustain) and the INR. In the event there is a breakdown in the US-Iran negotiations, resulting in renewed and prolonger war uncertainties, there is likely to be a lasting impact on the economic situation, as highlighted by the RBI Governor, which may in turn impact the earnings outlook as well as investor sentiment.

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