In just two months, the Reserve Bank of India (RBI) has sharply revised upwards its consumer inflation forecast to 5.7% from 4.5% for fiscal 2023. The Russia-Ukraine conflict has not only exacerbated the existing inflationary pressures, but also created new ones. And all this is happening in an environment where risks to growth remain firmly tilted downwards.

The war and ensuing sanctions have pushed up crude and commodity prices, which were expected to correct in 2022, and given a new lease of life to pandemic-induced supply bottlenecks. Prices of wheat, sunflower oil, aluminum, palladium, nickel, and fertilizers – commodities in which Russia and Ukraine are important players – have jumped.

These developments are broad-basing inflationary pressures in India as well, despite weak demand. In fiscal 2021, inflationary pressures came largely from food and to some extent from the core (which excludes fuel and food). Fuel inflation was benign. In fiscal 2022, with the hardening of crude prices, fuel emerged as the new driver of inflation and core inflation firmed up further. However, overall inflation was lower at 5.5% in fiscal 2022, compared with 6.2% in the previous year, due to drop in food inflation.

Recent data trends and uncertainty over the end of war and duration of sanctions suggest that fuel inflation is likely to stay firm and food and core inflation are set to harden from fiscal 2022 levels. Food is facing pressure from rising prices of imported edible oil and firming of farm inputs such as diesel prices, fertilizers, pesticides and animal feed.

Pressure on core inflation, which remained sticky at ~6.0% last fiscal, has not abated despite weak demand, and continues to face pressure from persistent supply shocks. As the RBI found it difficult to ignore inflationary developments, it signaled a shift in focus from reviving growth to mitigating inflation risks. The change in tone in its April meeting and narrowing of the liquidity adjustment facility corridor will prepare the markets for forthcoming repo rate hikes. We expect a change in stance to ‘neutral’ from ‘accommodative’, and a 50-75 basis points (bps) hike in the repo rate in fiscal 2023, beginning as early as June.

This has already firmed up the government’s cost of borrowing, with 10-year government bond yield now hovering above 7.2%. The borrowing cost for consumer and businesses will follow suit. Banks are raising their marginal cost of funds based lending rates post April monetary policy, indicating turn of the rate cycle.

The Russia-Ukraine conflict is also crimping the fiscal policy space. The government’s growth strategy hinges on the fiscal space for infrastructure development created by the delay in fiscal consolidation over the medium run as well as reshuffling of revenue expenditure towards fiscal spending in fiscal 2023. This is now being challenged by high crude and commodity prices, which have inflated the government’s subsidy bill. The accompanying cost overruns for infrastructure projects will reduce bang for the buck for infrastructure creation.