How Israel-Palestine war can upset RBI's inflation management

The ongoing Israel-Palestine conflict poses a significant challenge to the Reserve Bank of India’s (RBI) forecasts regarding crude oil prices at $85 a barrel and the exchange rate of 82.5 against the US dollar, which have a direct impact on inflation numbers.  

A day after Israel hit back, the crude oil prices jumped to $88.76 a barrel. The traders are setting their eyes on $90 level, which will then open the move to $95 a barrel, which it touched last week. The rupee is currently trading stable at 83.28 against the US dollar, but it is higher than the RBI’s projections. 

“Though, the conflict doesn’t pose any immediate threat to oil flows, there’s a risk of confrontation between US and Iran as it is anticipated that it was an attack backed by Iran,” says Ravindra Rao, VP-Head Commodity Research, Kotak Securities Ltd.  

According to the RBI, if the crude oil price goes 10 per cent above the assumption, domestic inflation could be higher by 30 bps and growth weaker by around 15 bps. 

Oil prices have been highly volatile in the last two months. In its October monetary policy statement, the RBI said crude oil prices firmed up sharply to around $95 per barrel in September in response to extended output cuts by key producing countries. This rise was on the back of strong demand and supply cuts. Two big oil producers—Saudi Arabia and Russia—have decided to continue with voluntary production cuts, which is expected to push up the prices in the near future. 

“An escalation of geopolitical hostilities and further production cuts by OPEC plus amidst strong demand pose upside risks to global crude prices,” states RBI in its policy statement. This statement, which was part of the monetary policy, came a day before the Hamas attack on Israel.  

The rupee value against the US dollar has also depreciated by some 50 paise since the August policy. The rupee value was around 82.73 in August and has now depreciated to 83.24 in October. The rising US interest rates as well as the stronger dollar are impacting the rupee, as FPI outflows are higher than inflows. 

In addition, there is a sudden uptrend in the value of the US dollar. The US Dollar Index (USDX), which tracks the US dollar’s strength against a basket of foreign currencies, has experienced a substantial increase over the past two months. Starting from 100 in early August, it has surged by approximately 6 per cent, reaching 106 this month. This upward trend signifies the growing dominance of the US dollar in relation to major global currencies. 

Several factors contribute to this strengthening of the US dollar. One key factor is the indication from the US Federal Reserve that there may be another interest rate hike on the horizon. The current short-term Fed rates are already at their highest point in 22 years. In addition, geopolitical uncertainties from Russia versus Ukraine and China versus US are driving investors to seek refuge in safe-haven assets like the US dollar. 

India’s current account deficit is likely to be under pressure. During the first five months of fiscal year 2023-24, the trade deficit stood at $37.49 billion, a notable improvement from the corresponding period when it was at $60 billion. As for CAD, data is available only up to June quarter. In the first quarter (April to June) of 2023-24, the CAD was lower than expected, accounting for just 1.1 per cent of GDP. This marks a significant decline from the 2.1 per cent of GDP recorded in the same quarter the previous year. But things could change in the second and the third quarter of current fiscal. It is important to note that the external situation is likely to undergo a change due to the sudden high crude oil prices.

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