Inflation dynamics: Ongoing Iran conflict will complicate policy choices

The Union government has done well to retain the inflation target of 4 per cent, with a tolerance band of two percentage points on both sides. This is for the next five years. The target is subject to review every five years and was retained in its first review in 2021 as well. The flexible inflation-targeting framework was adopted in 2016. Accordingly, the Reserve Bank of India (RBI) is mandated to keep the consumer price index-based inflation rate at 4 per cent. The central bank has to send a report to the government if it fails to achieve the target. There are several reasons why retaining the target made sense for the government. 

Research has shown that both the inflation rate and volatility moderated after the adoption of the flexible inflation-targeting framework. Besides, it is important that the framework is not disturbed without very strong reasons to do so. A big change in it could have affected expectations. A clear, rule-based policy framework enables easier implementation and effective communication. This reduces ambiguity and provides stability, allowing market participants to adjust to evolving macroeconomic conditions. A well-understood and predictable framework is particularly useful in times of stress. The six-member Monetary Policy Committee (MPC) of the RBI is scheduled to meet next week (April 6-8) to review the policy, and the meeting will be closely watched, given the external environment. The war in West Asia has significantly increased economic uncertainty. A prolonged conflict could complicate policymaking. The Union government, for instance, last week decided to reduce the special additional excise duty on petrol and diesel, which will significantly affect its finances if the war continues. 

An oil-price shock tends to reduce economic growth and increase the inflation rate. Stagflationary conditions are particularly difficult for central banks to manage. Policy intervention to contain the inflation rate can affect economic activity and further weaken the growth impulse. Thus, it is important to maintain the right balance. As things stand, the government has only selectively allowed the increase in global crude-oil prices to be passed on, which is likely to have a muted impact on inflation outcomes in the near term. However, if the war prolongs, inflationary pressure could build up in various ways. A shortage of gas, for instance, is affecting production in various sectors, which would soon start feeding into prices. It is also worth noting that the rupee is under pressure due to a possible increase in the current account deficit and lower capital inflow. The currency has fallen by over 4 per cent against the dollar since the beginning of the war and will add to inflationary pressure through the prices of imported goods. 

While India has adequate stocks of food grains, the hit to global fertiliser production could affect food production and push up prices. Projections released by the Organisation for Economic Co-operation and Development last week showed that, compared to its previous forecasts, the inflation rate for G20 countries could increase by 1.2 percentage points in 2026 to 4 per cent. For India, the projection has been increased by 1.7 percentage points to 5.1 per cent. The inflation rate for February was 3.21 per cent. This can increase sharply in the coming months. It would be worth watching how the MPC interprets the situation. Given the level of uncertainty, as things stand now, it would make sense to wait for more clarity.