Status quo on repo rate to continue as RBI gauges impact of oil shock

The closure of the Strait of Hormuz and disruption to 20% of global energy supply have pushed spot crude oil prices well past $100 per barrel. Futures markets indicate that prices will remain in the $100-120 per barrel range until July and remain elevated beyond that.

A key risk to both inflation and growth has thus materialized and is likely to persist for a quarter at least. Rupee depreciation is adding to these imported inflationary pressures, as the oil price spike has worsened the external flow position further by widening the current account deficit and triggering large FPI capital outflows.

While the Reserve Bank of India (RBI) has announced measures to curb speculation in the onshore forex market, the rupee's depreciation is likely to persist and add to inflationary pressures.

At present, the headline inflation remains below the target rate and with the excise duty cuts, the central government has ensured that the near-term impact of the adverse shock on inflation and growth is contained.

It is thus likely that the MPC will leave the repo rate unchanged at 5.25%, awaiting clarity on the duration of the oil market disruption, while acknowledging that higher oil prices have significantly increased the risk of inflation rising above 4% over the year.

The policy stance is likely to be retained as neutral, providing the MPC with the flexibility to act appropriately depending on the evolving macro-economic conditions.

The MPC will shift focus to keeping inflationary pressures in check, especially if the near-term inflation expectations of households rise sharply in response to higher fuel and food inflation. Persistence of inflationary pressures will depend on the duration and scale of the oil price surge and pass-through to the end consumers through higher retail prices and risks to food inflation from any urea shortage.

In all likelihood, the next move on the repo rate will be a hike. That said, a status quo is likely in the first quarter of the year at least. If inflationary pressures persist for three to six months or more and adversely affect consumption and growth, the MPC may have to consider the risks to growth.

The RBI’s baseline forecasts for quarterly real GDP growth and headline CPI inflation, and the deviation of the actual outcomes from these forecasts, will thus guide monetary policy actions over the year.

Real GDP growth is likely to be adversely impacted by the increase in negative drag from the external sector, while domestic drivers of consumption and public investment continue to support the momentum.

Net export contribution to headline growth is likely to turn sharply negative over the year, with import growth picking up on the back of higher prices of energy and industrial inputs.

Headline CPI inflation is already on a rising trajectory and the commercial fuel price hikes undertaken will push the headline inflation past the 4% target from the second quarter of the current fiscal year.

For the full year, the average headline inflation is likely to be around 4.4%, with risks to the upside, versus an average inflation of 2% in FY2025-26. Real GDP growth is likely to fall to around 6.5% with a balance of risks to the downside, compared to 7.6% in the previous fiscal year.

The monetary policy report to be presented along with the policy statement will provide an elaborate scenario analysis of these two key variables based on the underlying assumptions for oil prices, rupee-dollar exchange rate, fiscal policy and global growth.

The RBI’s base case forecasts will now consider significantly higher crude oil prices and a weaker rupee. In an inflation targeting framework, these forecasts provide an intermediate target for policy actions.

Given the high degree of uncertainty around the supply and prices of oil, gas and other key industrial commodities, an assessment of risks will also provide guidance on how much inflation can drift upwards and growth print lower in comparison to the base case. That in turn will determine the path monetary policy takes going forward.

In summary, the oil price surge has emerged as a major risk to inflation and growth, and its overhang will depend on how long it persists. The MPC, however, will maintain status quo for now, even as the RBI has stepped up exchange rate intervention measures.

(The author is chief economist, IndusInd Bank. Views are personal.)