Major disruptions, such as the West Asia crisis, that initially surface as supply shocks force central banks to ask a fundamental, almost philosophical question. Should the impact on the economy going forward be treated primarily as a process of demand destruction warranting monetary accommodation? Should it, instead, be viewed principally as an inflation driver that demands tightening going forward?
The monetary policy statement on Wednesday was predictably somewhat noncommittal in its answer to the question. This was to be expected. After all, the policy announcement came a few hours after the reported ceasefire between Iran and the US, the durability of which remains uncertain. Besides, even if the ceasefire were to endure and morph into a permanent truce, the extent of the damage to both oil production facilities and related global supply chains needs to be assessed carefully before arriving at a definitive answer. One has to be patient and let the data flow in.
That said, if one parses the language of the governor’s policy statement and the forecasts for growth and inflation, one could argue that the RBI has communicated its priority. Demand destruction seems to be a larger concern for the RBI than the inflation risk. To quote the governor’s speech, “Overall, the initial supply shock can potentially transform into a demand shock over the medium term.”
Besides, the governor’s unusually candid observations in the post-policy press conference that the real interest rate in the economy remains “high” at around 2% and that it is possible that policy rates remain low in the short to medium term seem to support the view that the Indian central bank is fretting more about growth deceleration than runaway inflation.
Are the central bank’s macro forecasts consistent with the dovishness that one senses in the text? That depends on how one reads the projections.
The central bank has projected a drop in the growth rate from 7.5% in 2025-26 to 6.9% in 2026-27, while inflation is projected at 4.6%.
One could say two things. For one, the RBI’s baseline projection for inflation leaves room for a hefty upside error that would still keep overall inflation well below the 6% ceiling of its mandated band. Second, the downside risk to growth that the RBI has flagged has a high chance of materialising. Growth could be closer to 6.5%. Should such a data mix actually emerge, a long pause, if not a rate cut, could well be possible.
In this context, the debut of core inflation as a variable that the RBI will forecast and subsequently publish alongside the MPC statement is noteworthy. The forecast for 2026-27 is 4.4%, with the qualification that, shorn of precious metals prices, it is likely to be even lower. This could mean the RBI’s reading of demand-led inflation, which core inflation represents, is fairly benign. An explicit discussion of the trajectory of core inflation enables the MPC and the RBI to better shape and control the narrative underpinning their rate decisions. This is particularly important in addressing policy dilemmas when supply shocks, such as a fuel price increase, raise headline inflation, but simultaneous demand compression keeps other prices low.
Currency Constraint
Coming to the rupee and the RBI’s recent actions to stem the rupee’s decline through off-market measures to curb speculation, one needs to remember a few things. While the RBI has always insisted that its sole interest lies in curbing excessive volatility, its actions have historically suggested it uses a floating target. Thus, intervention through dollar sales or indirect action tends to ramp up at specific exchange-rate levels. Over the past month, 93/$1 has emerged as a near-term target that the central bank has pulled out all the stops to protect.
It is possible to argue that a managed float works well for emerging markets, particularly one like India, which runs a significant current account deficit substantially funded by volatile portfolio flows. This, de facto, translates into a signal from the central bank, through its market or regulatory action, of a level or range of the exchange rate it finds compatible with the economy’s fundamentals.
Currently, the bulk of inflationary pressure stems almost solely from imported energy inflation. The first line of defence against this is to prevent dollar prices of energy from translating into higher rupee prices. Thus, intervention, both through the market and non-market regulation, is essential.
The rupee’s sharp fall is not a recent phenomenon, riding on the Gulf crisis. It has seen a continuous decline for over a year on the back of foreign investors selling and has severely underperformed most Asian peers in 2025 and 2026. The oil shock has simply added to the downward momentum.
The exchange rate is a gauge of a market’s underlying strength. While the first round of FPI selling in early 2025 was in response to factors such as high stock valuations of Indian companies, the rupee’s weakness has, through a curious twist, subsequently become a key factor in foreigners’ decision to sell. One could see this as a self-fulfilling doom loop, with exchange rate weakness triggering foreign investor selling that in turn has pressured the exchange rate down further. If the RBI’s recent actions are successful, it would help break this loop at least temporarily.
Governor Malhotra was quite emphatic in describing the curbs on speculation as a temporary response to an episode of severe stress in the currency, not the new normal for its intervention strategy. Old-fashioned intervention through spot and forward sales is seen to be more market-friendly, while soft capital controls, like anti-speculative curbs, are more draconian. Thus, these off-market measures should be used selectively but should, at the same time, aim to induce some permanent changes in trader and speculator behaviour.
While feeding the market more reserves was a difficult option after losing roughly $40 billion of reserves since the February peak of $729 billion, the RBI signalled quite clearly other weapons in its armoury. This might effectively prevent the build-up of large one-sided bets against the Indian currency in the future.
More unconventional measures, both in the form of capital controls or attempts to bring in lumpy dollar inflows ( the window for ‘subsidised’ hedging for FCNR deposits post the taper tantrum comes to mind), might be warranted even in the future, even if oil prices were to climb down from current levels. A fragile Middle East could impinge on remittances and NRI deposits, while the lasting damage to oil facilities could keep oil prices at a significantly elevated average level compared to the pre-crisis period.
Finally, is a dovish stance compatible with rupee defence? As local yields come down, would the carry on Indian bonds not come down and actually hurt the rupee? One concedes that supporting domestic growth and managing the currency is a difficult balancing act and might run counter to the logic of the impossible trinity associated with open capital accounts. That said, the Indian economy is far removed from the textbook world that undergirds this impossibility. The relationship between interest rate “carry” and exchange rate movements is far from straightforward in India. For one, a key driver of Indian capital flows is the stock market, which gets a leg up with a rate cut and should attract more foreign inflows.
In a world where tectonic shifts are happening in the blink of an eye, the RBI did the best it could. How well its strategy works depends on where the tectonic plates settle and how nimble the central bank remains in the future.
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