What looked like an unusually benign alignment of high growth and low inflation for India is now being tested by forces far beyond its borders. For a brief period, policymakers had the rare luxury of operating without the usual macroeconomic trade-offs. As Reserve Bank of India (RBI) Governor Sanjay Malhotra described it in December, growth at 8% alongside inflation at 2.2% marked a “rare goldilocks period”—an economy expanding strongly without stoking price pressures. That equilibrium is now under strain. The Iran war, the surge in oil prices, and disruptions to supply chains have begun to unsettle the macroeconomic environment. As risks to both inflation and growth rise simultaneously, the RBI once again faces the classic central banking dilemma it had briefly managed to avoid—whether to support growth or contain inflation.
Triple Threat
The outbreak of war in West Asia has sharpened India’s vulnerability to elevated crude prices and heavy gas imports. With the war showing no signs of an early end, the vulnerability has given way to despondency even though the government and the RBI have tried hard to cushion the impact. Rising import costs and emerging energy shortages are already weighing on businesses.
Firms are likely to curb production as they grapple with costlier inputs—exacerbated by a rupee that has weakened past 95 to the dollar—and tighter access to raw materials. At the same time, consumption demand is expected to soften under the pressure of higher prices. Adding to the uncertainty, the El Niño effect could lead to a sub-normal monsoon, hurting farm output and rural incomes. The combination of production cuts and weakening demand points to a loss of economic momentum even as inflationary pressures build.
While higher oil prices will undoubtedly fuel inflation, their impact on growth is likely to be more severe. The challenge is not just costlier crude but also energy shortages disrupting downstream sectors. Gas rationing has already hit commercial establishments. There is a growing sense that the shock is being underestimated. If it persists, the damage to growth could exceed the RBI’s earlier estimate that a 10% rise in oil prices reduces growth by 0.15 percentage points. Even so, the central bank may avoid sharp downward revisions to its FY27 growth projections, currently around 7% for the first half, to prevent signalling excessive pessimism.
Inflation, though a concern, is for now partly cushioned by the government and oil marketing companies absorbing higher crude costs. Even if inflation overshoots the RBI’s estimate—where a 10% rise in oil prices adds 0.3 percentage points—the pass-through is likely to be gradual. Supply-side pressures, such as lower food output due to fertiliser shortages, will emerge with a lag. In this environment, retail inflation of around 6%, or slightly higher, may have to be tolerated. The RBI had already nudged up its inflation forecast for the first half of FY27 from 4% to 4.1% in February; further upward revision is likely.
Policy at a Crossroads
This makes the policy choice clearer than it first appears. The Monetary Policy Committee would be well advised to prioritise growth and hold rates steady. Defending the rupee through aggressive tightening risks inflicting greater damage if growth falters sharply. What is required now is caution, not hawkishness. While concerns over the balance of payments—negative for two consecutive years—are valid, the response should focus on improving capital inflows rather than suppressing domestic demand. Measures to attract foreign investment, ease regulatory frictions, and deepen bond market participation would be more effective than raising interest rates into a weakening economy.