War, oil, and the stagflation threat

Stagflation risks loom large if the West Asia conflict prolongs and global trade faces sustained disruption, with an imperfect storm brewing for the Indian economy.

Elevated risks of wider energy supply disruptions from a prolonged Iran conflict are prompting a reset of India’s macroeconomic outlook. A sharper terms-of-trade shock, especially with Brent crude rising above $100 per barrel, could push the current account deficit (CAD) beyond 2.5 per cent of GDP and result in a balance of payments (BoP) deficit of nearly $85 billion.

The eventual impact on growth, inflation, and fiscal balances will depend on how the burden of higher crude prices is shared among oil marketing companies (OMCs), the government, and consumers.

With under-recoveries of OMCs already exceeding Rs 3 trillion at current price levels, the burden is likely to fall disproportionately on the government. This could translate into a minimum fiscal cost of around 0.5 per cent of GDP, adding pressure on public finances at a time when growth risks are intensifying.

The Reserve Bank of India (RBI) is expected to allow a calibrated depreciation of the rupee while intervening to prevent excessive volatility in financial markets. However, the policy trade-offs are far from straightforward.

The USD/INR exchange rate is projected to weaken towards 96, while the 10-year government bond yield could edge up to around 6.95 per cent.

There is no simple monetary policy response to an energy price shock of this nature. Before the conflict, the RBI’s focus was on improving monetary transmission, particularly in the bond market, supported by ample liquidity that kept overnight rates below the policy rate.

While direct pass-through of higher oil prices remains limited due to managed retail fuel prices, second-round effects—through inflation expectations, growth slowdown, and tighter financial conditions—are now shaping the central bank’s policy stance.

The threshold for conventional rate hikes remains high, given that the shock is supply-driven. At the same time, it remains to be seen whether the RBI will continue with abundant liquidity and sub-repo overnight rates. Despite consistent forex intervention, the rupee has remained under pressure, and the associated liquidity drain has been partly offset through bond purchases.

A sharp policy response in the form of interest rate defense—raising overnight rates to curb FX arbitrage—appears unlikely at this stage. USD/INR now looks poised to touch 96, while the 10-year yield may edge higher and touch 6.95 per cent.

System liquidity, which stood at around Rs 5 lakh crore, is expected to moderate to about Rs 4 lakh crore, with open market operations (OMO) injecting roughly Rs 1.7 lakh crore.

After adjusting for government cash balances, effective system liquidity may hover near Rs 1.6 lakh crore. So far, the RBI has infused approximately Rs 7.2 lakh crore in FY26 through various measures.

Continued forex intervention may necessitate further OMO purchases to ensure core liquidity does not fall below Rs 1 lakh crore in the first quarter of the new fiscal.

A key source of resilience, however, lies in India’s comfortable foreign exchange reserves. Even after accounting for potential stress outflows, reserves remain adequate. Additionally, India’s recent free trade agreements (FTAs) offer some cushion, with exports to partner countries amounting to $219 billion in FY25, against imports of $337 billion.

While these buffers provide some relief, a prolonged conflict and sustained oil shock could still pose significant macroeconomic challenges, raising the spectre of stagflation for the Indian economy.