First time in this rate cycle, RBI faces growth-inflation dilemma

It is probably the first time since he took over as governor of the Reserve Bank of India (RBI) in December 2024 that Sanjay Malhotra will face the classic growth-inflation tradeoff that central bankers dread. 

The going was good until war in West Asia started. The inflation rate was low with growth staying robust. Liquidity was comfortable, and bank lending rates were moderate. Asset quality, by and large, was holding up. 

The war threatens to alter the “goldilocks period”, which Malhotra referred to during the December monetary policy review.  The inflation rate was at 2.2 per cent with growth in gross domestic product (GDP) at 8 per cent during the first half of this financial year. This prompted the former bureaucrat to call this “a rare goldilocks period”. He reiterated his assessment during the February review. “We are certainly in the same sweet spot, maybe even better because growth is looking up,” he said. 

The economic situation has changed in the past one month. Chief Economic Advisor V Anantha Nageswaran summarised the impact of the West Asia war in the Monthly Economic Review, released over the weekend. In the preface to the report, he noted the impact of the war would be significant on growth, inflation, the fiscal situation, and external balances. He identified four channels through which the impact would be felt — supply disruption to oil, gas and fertilisers as well as exports; higher import prices; higher logistics costs; and remittances by Indians in the Gulf countries. 

The growth-inflation tradeoff arises because the Monetary Policy Committee has to take into account growth sacrifice if interest rates are to be raised. This consideration was not there so far since the start of the current rate-cut cycle began in February 2025.

“No more rate cuts (for now). Inflation is a major factor. Besides the war effect, El Nino is a possibility to be considered,” said Madan Sabnavis, chief economist, Bank of Baroda. 

The central bank will be making the projections for growth and inflation for FY27 during the next monetary policy review, scheduled April 6-8. The April policy will be the first under the new series for GDP and inflation. It will be also be the first for the inflation target period from April 1, 2026, to March 31, 2031. 

While the impact on inflation due to surging oil prices is still playing out, the influence on the exchange rate is immediate. The rupee depreciated over 4 per cent in March. On Friday, the currency hit an all-time low 94.85 to the dollar with intermittent intervention by the central bank preventing it from hitting the 95 mark. 

The foreign-exchange reserve data, available till March 21, showed foreign-currency assets, the largest component of foreign-exchange reserves, declined $16 billion since February 27. 

The central bank is seen intervening in both the spot and the forward market. 

The central bank on Friday came up with a direction capping the net open position involving the rupee in the onshore deliverable market at $100 million. The move will force banks to unwind large long-dollar positions,  which could be squared off in the near term, leading to immediate dollar selling and short-term support for the rupee. 

“Even if the RBI’s move pulls the dollar briefly lower, the conflict can push it higher again,” said Kunal Sodhani, head (treasury), Shinhan Bank. 

The widening balance of payments deficit will put pressure on the rupee. The balance of payments (BoP) deficit was $30.8 billion for April-December while the current account deficit was 1.1 per cent of GDP. 

“The escalation in geopolitical risks has resulted in BoP remaining in deficit in Q4FY26 with a jump in outflows in foreign portfolio investment,” said Gaura Sen Gupta, chief economist, IDFC Bank, in a report. 

The Ukraine war four years ago also started in February. The RBI then convened an unscheduled meeting in May, when the rate increase began. The cycle ended in February 2025 through a rate decrease. 

The difference between 2022 and 2026 is that the policy repo rate was much lower then — 4 per cent, as compared what it is now — 5.25 per cent. This probably gives space to the rate setting panel to wait for some more time to assess the war’s impact on growth and inflation. 

Nageswaran said demand moderation would ease the RBI’s dilemma. 

“If demand moderates in response to higher prices, the RBI will be more inclined to treat the inflationary impact as a supply shock. Otherwise, it may be compelled to watch for second-round effects of higher import costs on inflation and respond accordingly,” he said.