RBI Cannot Afford to Look Through This Shock

The conclusion following the June monetary policy meeting has been that the interest rate is not the tool to address the fall in the rupee’s exchange rate and that the Committee rightly kept the repo rate and the stance unchanged, even as the Reserve Bank of India, along with the government, took steps to boost foreign exchange inflows to address Balance of Payments concerns.

A widely held view following the meeting is that the MPC can safely look through the inflation shock because monetary policy cannot produce more crude oil or lower global commodity prices. That conclusion may prove too mechanical.

The most important signal from the latest policy was not the unchanged repo rate. It was the RBI's inflation projections. Headline inflation for 2026-27 was revised sharply higher to 5.1%, with inflation projected to remain above 5% through much of the year. More importantly, the RBI also revised its core inflation forecast higher by 30 basis points to 4.7%.

Core inflation excludes the direct effect of food and fuel prices, and when the RBI raises its core inflation forecast, it is effectively signalling concern that the energy shock may not remain confined to energy. It is acknowledging the possibility that higher fuel costs can begin to seep into transportation, services, manufacturing costs and inflation expectations more broadly. The RBI is therefore signalling concern that second-round effects may emerge.

That makes it difficult for the Monetary Policy Committee to simply dismiss the shock on the grounds that it is supply-driven.

The case becomes stronger because the risks are not limited to energy prices alone. The RBI itself continues to see upside risks to inflation from food prices. If weather conditions disappoint and food inflation rises alongside fuel inflation, the probability of broader price pressures increases materially. Simultaneous increases in food and fuel prices tend to have a disproportionate influence on household inflation expectations, making the eventual pass-through into core inflation more likely.

The growth backdrop also reduces the policy dilemma. The RBI continues to project growth at 6.6% in 2026-27. That is not an economy that requires emergency monetary support. Stronger growth gives the MPC greater room to respond if inflation risks broaden.

The arithmetic on real rates is becoming increasingly uncomfortable as well. With inflation projected at 5.1% and the repo rate at 5.25%, the RBI's own forecasts imply almost no real-rate cushion. That becomes increasingly difficult to justify if inflation risks continue to tilt upwards.

Global conditions may further strengthen the case for normalisation as markets are increasingly debating whether the Federal Reserve may need to tighten further if inflation proves sticky. Any rise in US rates would narrow interest-rate differentials at a time when the RBI is simultaneously encouraging large capital inflows and managing external-sector pressures.

If the RBI waits too long for second-round effects to become undeniable, it may again find itself tightening after the inflation process has already broadened. The August meeting should therefore remain live, not because the RBI needs to defend the rupee or respond mechanically to higher crude prices, but because its own forecasts suggest policy is moving uncomfortably close to falling behind the inflation curve.

A 30-basis-point upward revision in the core inflation forecast to 4.7%, continued upside risks to food prices, growth still projected at 6.6%, and the absence of any meaningful real-rate cushion together suggest that the case for keeping August live is stronger than markets currently assume. Even if the first move ultimately comes in October, the broader policy trajectory appears increasingly clear. If inflation evolves broadly along the RBI's own projections, a cumulative 75 basis points of tightening over the coming quarters, taking the repo rate back to 6%, would be difficult to argue against.