In many ways, the Reserve Bank of India’s (RBI’s) June policy will be the calm before the storm that’s expected to hit the economy on multiple fronts.
The first of these is inflation, with a surge in input cost pressures expected for producers across fuels, chemicals, metals, and so on. The jump in wholesale price index (WPI) inflation to a 42-month high in April has put everyone on high alert for a potential surge in consumer price index (CPI) inflation.
One major saving grace has been the limited pass-through of the fuel price shock to consumers, which has kept CPI inflation below the RBI’s 4% target. Only in May were retail petrol and diesel prices increased, passing some of the burden to consumers.
Moreover, El Niño conditions have added upside risk to food inflation, with the India Meteorological Department (IMD) predicting a below-normal monsoon. The combination of fuel and food inflation pressures poses upside risk to the RBI’s CPI inflation estimate of 4.6% for FY27.
The second front is the negative impact on gross domestic product (GDP) growth due to the surge in input costs and potential supply-side shortages. Growth held up In Q4FY26, with consumers largely protected from the energy shock. The performance of listed companies improved, with margins supported by a drawdown in inventories. The impact of the surge in input costs will be more visible in Q1 and Q2FY27, with margins expected to be hit. If supply-side shortages emerge, there is downside risk to the RBI’s real-GDP growth estimate of 6.9% for FY27.
The third front is the rupee and the need to boost capital inflows. Pressure on India’s currency has persisted for more than a year due to a sharp slowdown in capital inflows. The capital account surplus dropped from 2.6% of GDP in FY24 to an estimated 0.1% in FY26. A broad-based reduction is seen across foreign direct investment (FDI), foreign portfolio investors (FPI), and debt inflows. Consequently, financing even a modest current account deficit of 0.8% of GDP in FY26 has become a challenge.
The slowdown reflects tight global financial conditions and domestic factors such as weakness in the private capex cycle and low investment in research and development (R&D). The West Asia crisis has increased complexity, with the current account deficit now expected to widen to 2.4% of GDP in FY27. If the crisis persists for long, comfort on foreign exchange reserves could diminish, making it essential to attract capital inflows and restrict non-essential imports.
Choosing the right tools
So which front of this storm should monetary policy focus on, and which fire should be doused first? The answer lies in the nature of the problem and who has the right tools. The inflation issue is driven by a supply-side shock from the surge in fuel prices, at a time when the economy has excess capacity. This is reflected in persistently low core CPI inflation and a current account deficit below 1% of GDP for the past three years. A rate hike will depress demand but not address the supply shock. Moreover, the West Asia crisis poses downside risk to growth, which should become visible in the coming months.
What about the currency and the need to boost capital inflows? Will a 50-75 basis points (bps) rate hike cycle help? The simple answer is no, as interest rate differentials have narrowed significantly. US Treasury yields are likely to stay elevated, reflecting worsening fiscal metrics in the US and limited policy space for the Fed due to high inflation. If interest rates are used for currency defence, it will require a much steeper hiking cycle to be effective—at significant growth cost.
How should the RBI navigate these challenges? In the June policy, the central bank has space to remain on pause and monitor incoming data. Unlike central banks in developed markets, where inflation has exceeded targets for years, India’s inflation has been below the 4% target for 15 months. On the external front, the best solution would be to bolster capital inflows via external commercial borrowings or foreign currency non-resident (bank) deposits. The RBI may need to subsidise hedging costs to make these schemes viable for investors and borrowers.
The good news is India’s macro stability indicators are on a much stronger footing than in 2013, with adequate forex reserves, a low current account deficit, and low inflation. This provides much-needed policy space to craft a solution without sacrificing growth at the altar of inflation or currency stability.
Gaura Sen Gupta is chief economist at IDFC First Bank.