Uncertainty Begets Monetary Policy Uncertainty

One of the cardinal principles of monetary policy is that when entering a dark room, policymakers move in small steps. Central bankers refer to this as Brainard conservatism, or the attenuation principle, articulated by William Brainard in his 1967 paper, “Uncertainty and the Effectiveness of Monetary Policy.”

The principle has been used by central banks to tighten monetary policy in small and sparse steps. This cautious approach is viewed as a risk management approach to policymaking. In the face of uncertainties, you don’t have to stay put, but you do what you think is right, and you temper what you are doing on consideration of uncertainty. When the MPC meets every two months, one doesn’t even have to change the policy rate each time, especially if there is parameter uncertainty or a lack of clarity on the new normal. This specially makes sense when the geopolitical and economic environment is hazy, and the extent of global spillovers is unclear.

On December 10, 2025, in these columns, I had questioned, “Are we in the Goldilocks scenario?” Noting large uncertainties, I cautioned that while the current macro-environment looked enticing, surging growth and vanishing inflation suggested a fragile equilibrium, a lull before the storm. That storm gathered pace as we entered 2026, causing the RBI to use some capital control measures that are discussed later in this column.

But while commenting on the RBI’s April monetary policy announcement, one should have empathy for RBI Governor Sanjay Malhotra. Formulating it must have been a nightmare. One doesn’t know if he got up at 5:30 AM that morning to check on Trump’s deadline and found his tweet, which came two hours earlier, giving Iran a two-week reprieve and central banks a temporary respite from heightened stress. It has given   lasting peace a chance, as either side can now afford to swerve without being seen as completely chickening out.

Asset prices have rallied on the policy day. The Sensex gained 4%, the Nifty 3.8%, and Indian gold prices 2.5%. Bonds rallied significantly, with the benchmark 10-year government bond yield (6.48% GS 2035 security) dropping 12 basis points, cumulatively 22 bps since April 3. The Indian rupee gained 44 paise, or nearly 0.5%, in a single day. Though the rebound could be temporary, it can bring some beneficial effects for the real economy through financial accelerators if the truce lasts.

Questionable Truce 
Yet, geopolitical and economic uncertainties remain rather large. No one is clear that Israel will honour the ceasefire, even if the US does. Netanyahu has stated that the US-Iran ceasefire ‘does not include Lebanon’. Lebanon has a considerable presence of both Hezbollah and Hamas. The former is a significant ally of Iran and protects Shia interests in a country that is about half and half in its Shia-Sunni composition. Hamas, while being Gaza-based, protects the interests of Palestinian refugees, who are mostly Sunni.

Hamas has launched attacks on Israel time and again since 1989, including the October 7, 2023, rocket attack from southern Lebanon, which started the present conflict. Hezbollah joined these attacks a day later under a new alignment of the ‘Axis of Resistance’. The Houthis are an important part of the Axis, and these Yemen-based Shiites have significant disruption potential for oil supply chains. Their presence extends to East Africa in Somalia, Sudan, and Eritrea. In addition, Iraqi militias with their several splinter groups form the Popular Mobilization Forces (PMF) and more, as also, the Syrian Popular Resistance (SPR) operate besides several other micro groups and sleeper cells of the Axis around the globe.

So, Trump’s Gaza plan, the Board of Peace and his project Sunrise, a massive $112 billion reconstruction to transform the war-torn Gaza enclave into a high-tech "Riviera of the Middle East", is reflective of a poor understanding that forms the US world view that includes an illusory hope that it can force peace in the Middle East while alienating most of its population.

One expects central bankers to understand this and not suffer from short-termism even as markets get carried away and beat the street indices in rallies that are always subject to the Newtonian spirit of “What goes up, must come down”. The RBI’s policy decisions, though not all aligned with its baseline forecast, exhibited an adequate understanding. But what is material is that the RBI astutely kept its policy options open on the policy levers it has, even while hoping to impart confidence to the markets through its forecasts and communication.

Rate, Stance, Projections
The Brainard principle completely justifies the RBI MPC’s decision to keep its policy rate and stance unchanged at 5.25% and “neutral”, respectively. The rate decision was unanimous. We will have to wait for the MPC Minutes on April 22 to know if all members agreed with the stance, as, in the past, Prof. Ram Singh has been asking for a change in the monetary policy stance from neutral to ‘accommodative’ (easy), the rationale for which must have weakened further in the current circumstances.

It is not clear what made the RBI so “gung-ho” on growth prospects. It has projected GDP growth at 6.9% for the full year. This is in line with the 6.8-7.2% by the Economic Survey that was made before the Strait of Hormuz closure, and the RBI forecast must have been finalised before Trump’s two-week ceasefire. Had the RBI read Trump so well as to trust that he will always reverse his threats to save the markets?

RBI’s structural model projections, generally based on its Quarterly Projection Model,  QPM 2.0, in October 2025 had placed growth at 6.6%, though with a wide uncertainty band. Its April 2026 projections, made on a wider information set than the structural model, have lifted the growth projection when the economic environment has worsened. The RBI’s projections are the same as the median forecast of the Survey of Professional Forecasters, or SPF. Also, S&P in March 2025 had lifted India’s growth projection from 6.7% to 7.1%. But the RBI does its own independent assessment, and this may have been impacted by higher growth rates in the new GDP series despite lower nominal GDP numbers, and also by the recent acceleration in many high-frequency indicators such as credit growth, GST collections, and vehicle registrations. However, these relate to the previous fiscal year, and the trend may change.

The IMF, in its WEO update in January 2026, had forecasted India’s growth for 2026-27 at 6.4%. The World Bank, in a report released Wednesday , has projected India’s growth at 6.6%. Moody’s, on April 6, 2026, had slashed India’s 2026-27 growth projection to 6.0% from 6.8% earlier. Most global investment banks are also projecting a much lower growth rate than the RBI.

Gloomy Picture
RBI’s forward-looking surveys also have a different story to tell from the RBI’s projections. Consumer confidence is dwindling. Urban consumer confidence exhibits a sharp deterioration in the Current Situation Index of the survey, and also for the fiscal year that has now begun. Similarly, rural consumer confidence has also dropped both for the current situation and future expectations. Most of the RBI’s business surveys in their latest rounds indicate some softening in demand conditions with moderation in optimism. Even more importantly, they show a build-up of cost pressures. Optimism on loan demand and loan terms and conditions has moderated across sectors in April–June 2026-27. Despite higher capacity utilisation in October–December 2025-26, firms have clearly indicated that they expect demand conditions to soften, and their optimism on order books and capacity utilisation has been severely dented for 2026-27.

While the RBI’s growth projections may be on the higher side, the uncertainty bands have been distended, and the fan charts show that the balance of risks to growth has shifted to the downside. In all fairness, in contrast with earlier assessments where risks around the central projections were fairly balanced, the RBI, in this policy, has spelt out that further escalation of the conflict, its continuation over a wider geographical spread, and uncertainty regarding the damage to the energy infrastructure, apart from weather-related events, pose downside risks to its baseline.

Elevated Inflation Risks 
The baseline inflation projection of 4.6% for 2026-27 seems to be well calibrated. The risks that inflation can come back remain significant.

First, exchange rates are random walks, but the dollar/rupee exchange rate is unlikely to live up to the RBI’s baseline projection of 94 for the year. For it to materialise, it may require (i) the dollar to weaken this year, which still looks difficult, and (ii) capital inflows to renew and the BoP deficit to be smaller than the current projections suggest. The dollar index had already weakened in the first half of 2025, and market expectations that it will weaken more in the first half of 2026 may not materialise, given the recent strong US labour market data and supply chain disruptions. Even though the chances of one rate cut during the whole of 2026 shot up on the policy day from 14% to 43% due to the ceasefire announcement, there is no clarity that it will come.

Second, meteorological forecasts indicate that the current La Niña conditions could quickly change, with a high probability (62-70%) of El Nino conditions developing this summer during June–September 2026. There is a 1-in-3 chance that a strong/super El Niño can hit later in the October–December quarter. The El Nino shock can raise the headline inflation rate by 40 bps.

Third, high global crude prices are likely to feed through to domestic inflation, and muted inflation in line with a 4% target may require many fortuitous developments, such as crude falling all the way to $60 a barrel, which looks rather difficult given that energy infrastructure has already been hit in the Middle East. The forward curve across tenors eased by almost $6 a barrel on an average basis on the policy day after the announcement of the ceasefire, and despite a significant backwardation in the futures, its March 2027 contract trades marginally above $75 per barrel, and so Brent may still average around $84 for the fiscal year. Any skirmishes during the rest of the year, further damaging energy infrastructure, could take crude oil above the RBI’s average of $85 a barrel for 2026-27.

This will have significant ramifications, and possibly the RBI understands this, as its fan charts show a sharp upside skew in inflation, with, at the 50% confidence interval, inflation could breach 7% by the year-end. This could especially happen if inflation expectations become unhinged. The government’s decision to delay the passthrough of rising crude oil prices to domestic petro-product prices can bring back inflation later through wider-than-budgeted fiscal deficits, and the delayed adjustment can come in the form of a discrete change in domestic energy prices, having a bigger impact on inflation expectations.

Unless oil prices correct more and stay muted, its baseline projection of an average 5.2% in October–December 2026-27 may not hold, and there is a chance that even the upper tolerance band of 6% inflation could be breached. Oil prices will have a more significant role in determining the headline inflation rate than before, because the CPI, with an updated base of 2024, captures the dependence of transportation costs on petrol and diesel much better in the overall consumption basket. The weights of these two fuels have more than doubled compared with the CPI with a 2012 base.

With these changed weights, the RBI now estimates that if crude oil prices are higher by 10% than the baseline, assuming full pass-through to domestic product prices, inflation could turn out to be higher by around 50 bps instead of 30 bps estimated earlier. Also, the rupee depreciation shock could have a greater impact on inflation. A 5% depreciation over the baseline could raise inflation by around 40 bps instead of 35 bps.

Extended Pause a Folly
Will policy rates be kept unchanged for the entire 2026-27? In my view, the probability is low even if the Fed remains on hold. It may happen only if core inflation falls distinctly below the RBI’s projected average of 4.4%, but not so much as to lead headline inflation to a sub-3% trajectory. Core inflation has a marked effect on the QPM-projected path of the policy rate required to keep inflation at the 4.0% target. The RBI may get room to cut its policy rates if disinflation is large.

On the other hand, the odds are that headline inflation may move to above the 5% range later in the year. Rate hikes in the second half of 2026-27 are very much a possibility should the inflation trajectory get lifted above or close to the 6% upper tolerance level. So, should the RBI start preparing the markets for rate hikes? The April policy may have been too early for that when the path itself is unclear, and business and consumer confidence are already dipping. Central bank communication is more of an art than a science. The RBI may have rightly deferred to the Brainard principle, even though central banks are required to act in a forward-looking manner.

The problem, however, remains that inflation may return, likely from the cost-push side rather than the demand-pull side, and thus be accompanied by a slowdown in growth. This will expose the limitations of monetary policy in dealing with stagflation. However, it must be remembered that, in addition to monetary policy, fiscal policy is another arm for aggregate demand management. Supply-side economics, in the emerging-market context, means expediting structural reforms and regaining credibility, offering the best offset. This will also help bring an end to the sudden stop in capital flows that has been at the heart of rupee depreciation.

Managing the Trilemma
At the end of March 2026, the RBI had foreign exchange reserves of $688 billion, of which foreign currency assets were $551 billion. The RBI reported its net outstanding forward dollar sale positions at $67 billion in January, though this may have risen further as the rupee came under pressure and NDF positions were built up.

RBI had, over the years, been taking well-sequenced capital account opening measures in small but sure steps. As part of this, the RBI had given banks the freedom to set their net overnight open position limits up to 25% of their total capital, counting CET 1, AT1 and Tier II. However, on March 27, it imposed a cap of $100 million, applicable since April, forcing banks to abruptly unwind their long dollar, short rupee positions that market sources estimate were in the vicinity of $35 billion. On April 1, it further hit the arbitrage trades by prohibiting banks from offering rupee non-deliverable forwards to resident and non-resident clients. It further said that companies cannot rebook cancelled forward contracts.

In the face of evolving pressures, some measures were needed. Soft capital flow measures (CFMs) are a legitimate tool for preserving macro-financial stability in emerging markets, which are confronted with the trilemma problem. They cannot, at the same time, achieve the goals of exchange rate stability and set policy rates entirely on domestic growth-inflation trade-offs while allowing capital flows in and out of the country unimpeded.

In the short run, bank balance sheets may be somewhat hit by mark-to-market (MTM) losses, but, on a ballpark estimate, this hit could be just 1% of banks’ annual aggregate profits. Some banks may be genuinely affected as they will not be able to hedge their onshore positions through NDFs. Banks have a legitimate grudge that they had built positions legitimately under the prescribed regulatory regime. But it must be understood that macro-financial stability is a public good and is very much in their own interest.

It is true that there were other, less blunt, measures that had been taken by the RBI in the past, and they could have been sequenced ahead to signal intent. But the RBI’s decisive action has certainly eased pressure on the rupee. It was also intended to materially protect banks against much bigger potential losses if global volatilities accentuate, as MTM movements can turn large if uncertainty rises further.

The RBI legitimately must prioritise resilience in current circumstances. Soft capital flow measures, or CFMs, as well as macroprudential measures, or MPMs, which are blessed as part of the IMF’s Integrated Policy Framework, must remain in its toolkit, as it is the EMEs that face the brunt of capital flow volatility. If Iceland could impose strict capital controls and maintain them for long, even after having capital account convertibility, there is no reason why an EME can’t take measures to forestall the possibility of it developing into a currency crisis. It may hamper the endeavour towards capital account convertibility and rupee internationalisation, as it is best not to reverse a liberalisation measure, as that affects investor confidence. But crisis-prevention must precede all other considerations.

The RBI must stay glued to its time-tested exchange rate management policy that allows flexibility but not free float. We must realise that geopolitical and economic uncertainties beget monetary policy uncertainty, and that managing the trilemma is a core part of monetary management, even if we have an inflation-targeting regime.

* The views here are strictly personal.