Policy Caution Likely As Inflation Risks Loom

India’s inflation debate is again becoming less comfortable. Crude oil prices are testing $100 per barrel, rainfall remains in a double-digit deficit territory, and global shipping routes face renewed geopolitical and weather-related risks. Any one of these would warrant caution. Together, they strengthen the case for policymakers to stay vigilant, even if near-term inflation prints have been softer than expected.

A de-escalation in geopolitical tensions could still cool crude prices. But the risk premium is unlikely to disappear quickly. Uncertainty over control of key maritime passages, the possibility of repeated flare-ups even after any ceasefire, and risks of deteriorating security around both the Strait of Hormuz and Bab-el-Mandeb could keep freight costs elevated. El Niño adds another layer of risk. If water levels fall sharply, key transit corridors could face disruption. The Panama Canal Authority has already announced a temporary 5% reduction in daily booking capacity because of lower water levels; in 2023, transit traffic was cut by almost half.

Uneven Risks
The domestic inflation risk is equally important. Better rainfall in July has helped kharif sowing regain momentum, with the year-on-year shortfall narrowing to 6% as of 17 July from 16% a week earlier. But the broader backdrop remains fragile. The monsoon deficit is still the widest since 2019, and around half of reporting districts continue to face rainfall shortfalls of more than 20%. Reservoir levels, at 38% of capacity by 23 July, are close to the decadal average and well below last year’s 61%.

This matters because the damage may not be limited to the current summer crop. If El Niño conditions lead to drier weather after mid-August, weak soil moisture and inadequate reservoir storage could also affect the winter crop. The next few weeks will therefore be critical not just for food prices, but also for rural incomes and monetary policy expectations.

Acknowledging important buffers is important. Irrigation coverage is better than it was a decade ago. Government stocks are comfortable and exists beyond cereals. Policy intervention can also smooth temporary price spikes. For instance, onion and pulses stocks can be released ahead of the festival season if prices continue to firm, according to media reports. Imports can be increased to narrow domestic supply-demand gaps. The new CPI basket also reduces the mechanical pass-through from food prices to headline inflation, with food’s weight lowered to 35% from 40%.

But these offsets may not fully neutralise the inflation risk from a large and uneven rainfall deficit. This is because inflation risks are not evenly distributed across the food basket. Rice is less worrying because of better irrigation coverage and large public cereal stocks, which are nearly three times the prescribed norms. The more vulnerable categories are pulses, vegetables, sugarcane and oilseeds. These crops are more dependent on timely and well-distributed rainfall, and therefore more exposed to weather shocks. For instance, nearly two-thirds of pulses production is rain-fed. The sown area for pulses was down by over 15% until 17 July (compared with a decline of just 1% year-on-year for rice), a fall sharply larger than for all crops put together.

This is why the upcoming Monetary Policy Committee meeting is likely to retain a cautious tone. June-quarter inflation has undershot the MPC’s projections by 30-40 basis points, and that may allow the MPC to tweak its 2026-27 CPI forecast lower from the current 5.1%. But any downward revision is likely to come with a strong emphasis on live upside risks from El Niño, global energy prices and possible sea-route disruptions, in our view.

Sticky global inflation risks and rising global yields could become a pressure point, particularly if policy-led capital inflows lose momentum later in the year. Renewed depreciation pressure on the rupee would further complicate the inflation outlook. While a rate hike is not our base case for the financial year, the risk of 50 basis points or more of tightening would rise if inflation moves towards an average of 5.3-5.5%.

The August MPC meeting may be too early for a decisive rate move. Capital flows triggered by recent policy announcements are still playing out, and rainfall and sowing progress through mid-August will be critical in assessing the need and timing of any policy response. The market is thus likely to focus less on the rate decision itself and more on the MPC’s tone: Does it still view a potential December-quarter inflation spike as temporary, or is the reaction function becoming more sensitive to persistent supply-side risks?

For now, the message is simple. India’s inflation has been benign so far, but the cushion is thinner than it appears. Oil, monsoon and maritime risks are moving together — and that makes policy caution necessary.