RBI policy expectations: Safeguarding growth amid a supply shock

With limited policy space amid a global supply shock, RBI is likely to hold rates, balancing inflation risks with the need to protect growth

As the West Asia crisis enters its second month, the outlook for the global economy is turning increasingly grim. The IEA has termed it the worst oil shock in history, with comparisons to Covid-19 due to widespread supply-side disruptions across fuels, gas, chemicals, and even metals. The war has also sharply raised freight costs, pushing up the cost of imports globally.  However, a key difference between the Covid-19 shock of 2020 and the West Asia crisis of 2026 lies in the availability of policy space to support growth. 

When Covid-19 struck, inflation in developed markets (DMs) was low at 1.4 per cent in 2019, and government debt stood at 103.6 per cent of gross domestic product (GDP). In response, unprecedented fiscal and monetary easing was unleashed, which helped global nominal GDP recover to pre-Covid19 levels by 2021. 

In contrast, the West Asia crisis has emerged at a time of elevated inflation in DMs (2.5 per cent in 2025) and already high public debt (110 per cent of GDP). Consequently, both fiscal and monetary support are far more limited than during Covid-19.  This is evident in the ECB’s willingness to raise rates amid upside inflation risks, while the US Fed can, at best, keep rates steady and look through a supply shock. 

India also faces constrained policy flexibility. General government debt remains elevated at 82.3 per cent of GDP in 2025-26 (FY26), compared with around 70 per cent in the pre-Covid period. This crisis has emerged at a time when markets were already grappling with heavy central and state bond supply. Fiscal policy, which is better suited to addressing supply-side shocks, is therefore bearing the brunt of the adjustment. The Centre has moved swiftly by cutting excise duties on petrol and diesel, while the residual shock is being absorbed by oil marketing companies (OMCs), which are incurring losses. Subsidy expenditure on fertilisers and LPG is also likely to rise. The resulting risk of fiscal slippage is estimated at 0.3 per cent of GDP in FY27, implying persistent upward pressure on bond yields. 

Monetary policy is constrained by the impossible trinity. India–US rate differentials are near historic lows, contributing to a 10 per cent INR depreciation over the past year. Capital flows were already weak, with a BoP deficit of $30.8 billion in FYTD26 (until Q3). The crisis has worsened this through a higher oil import bill and sharp FPI outflows ($13.6 billion in March 2026).  The last time India saw such a large FPI outflow in a month was during Covid-19 ($15.9 billion in March 2020). However, unlike post-Covid, limited DM monetary policy easing space suggests EM capital flows will remain weak in FY27. 

The key question is whether the RBI should raise rates? Historically, the RBI has tightened policy during a supply-side shock only when headline consumer price index  (CPI) exceeds 6 per cent for a few months. FY27 CPI inflation is estimated at 4.9 per cent, with much of the energy shock absorbed by the government and OMCs, even after factoring in some retail fuel price hikes. A rate hike would only deepen demand destruction without addressing supply constraints. Fiscal policy is better positioned to respond to supply-side shock, limiting the hit on consumers. 

Headline inflation is unlikely to breach the 6 per cent threshold, while the crisis poses significant downside risks to growth. Supply disruptions could lower GDP growth by 0.5ppts if concentrated in Q1FY27, and by 1ppt if it extends into Q2FY27. Hence, the optimal monetary response is for the RBI to hold rates steady and ensure credit flow, particularly to at-risk sectors such as exporters and MSMEs. 

On the currency front, INR depreciation reflects capital account weakness. The RBI has limited foreign exchange (FX) reserves cover of 9 months (spot reserves plus forward book). If crude oil prices average at $90 per barrel in FY27, this import cover could easily reduce to less than 7 months by March 2027. Cognisant of this, RBI has begun to deploy unconventional measures to stem the depreciation pressures, such as restriction on net open position for banks. The next set of measures need to focus on boosting capital inflows without raising domestic cost of funding.

The writer is chief economist at IDFC First Bank