India’s monetary policy faces a delicate balancing act as rising inflation expectations and external shocks increase the importance of maintaining an orderly exchange rate, according to a report by SBI Research released on Tuesday.
The report argues that while central banks often respond cautiously under uncertainty, excessive gradualism could risk unanchoring inflation expectations, particularly in the current environment shaped by geopolitical tensions and currency pressures.
Drawing on the “Brainard principle of attenuation”, the research note said policymakers tend to adjust policy tools more conservatively when uncertain about their effects. However, SBI Research cautioned that such an approach may backfire if inflation expectations begin to drift.
“In uncertain times, monetary policy must prioritise anchoring inflation expectations, which directly implies the need for orderly exchange rate movement,” the report said.
Inflation expectations in India have risen notably following the West Asia conflict, with near-term household expectations increasing sharply. According to the report, three-month-ahead expectations rose by 60 basis points, while perceptions of annual inflation in rural and semi-urban households increased by 50 basis points.
Business surveys also point to heightened concerns. The IIM Ahmedabad Business Inflation Expectations Survey showed a “very sharp increase” in one-year ahead inflation expectations, signalling growing unease among firms. Minutes from the Monetary Policy Committee (MPC) indicate that at least four of six members flagged risks of unanchored inflation expectations, reflecting a broader concern within the central bank.
Inflation Risks Lie In The Exchange Rate
The report highlighted that the key transmission channel for inflation risks lies in the exchange rate. Depreciation of the rupee raises imported inflation, especially through higher costs of commodities such as oil and gold.
Between April 2025 and February 2026, the rupee depreciated by 6.39 per cent against the dollar, with a further 3.63 per cent decline observed after the onset of the West Asia conflict. SBI Research noted that the current pace of depreciation is “not in line with India’s macro fundamentals”, underscoring the need for policy intervention.
“Exchange rate cannot be construed as a shock-absorbing mechanism in perpetuity,” the report said, warning that sustained depreciation could amplify inflation through second-round effects. Beyond currency pressures, the report pointed to structural vulnerabilities in India’s balance of payments (BoP). It projected the overall BoP to remain in deficit at USD 28 billion in FY27, marking the third consecutive year of negative balances.
The current account deficit is expected to widen to USD 54.1 billion, driven by a growing trade deficit, while the capital account surplus is projected at USD 26.5 billion, assuming stable capital inflows. To address these challenges, SBI Research called for a “comprehensive set of measures” to support external balances and stabilise the rupee.
Among the proposals is a potential foreign currency deposit mobilisation scheme targeting the Indian diaspora, similar to past initiatives such as Resurgent India Bonds. However, the report cautioned that higher global yields and hedging costs could limit the attractiveness of such schemes unless carefully calibrated.
It also suggested tightening outward remittances under the Liberalised Remittance Scheme (LRS), particularly for discretionary spending such as travel, which accounts for around 55 per cent of such flows. The annual LRS limit of USD 2,50,000 could be temporarily reduced for select categories, it said.
Additionally, the report recommended rationalising tax treatment for foreign investments in government securities to attract long-term capital, noting that policy uncertainty can deter global investors. Gold mobilisation and easing regulatory frictions were also identified as potential areas to bolster external stability.
The report concluded that monetary policy alone cannot address supply-driven inflation shocks and emphasised the importance of coordinated measures to manage expectations and external vulnerabilities. “Ensuring inflation expectations remain anchored requires both monetary and structural responses, with exchange rate stability playing a central role,” SBI Research said. |
