Iran War Impact: Energy price shock, stagflation risks, and policy trade-offs

The escalating conflict in the Middle East has created significant uncertainty in terms of the duration of the conflict, its ripple effects on the energy supply chains, and the economic spillovers. India faces a complex set of challenges that risks disrupting the current “Goldilocks” economic environment of strong growth and low inflation. India’s exposure to the energy shock India’s vulnerability stems from its heavy dependence on energy imports. The country imports over 85% of its domestic oil needs. Approximately 50% of India’s crude oil and LNG supplies transit through the Strait of Hormuz, along with over 90% of imported LPG. As a result, India is exposed to both the energy price shock and the supply (volume) shock. A sustained energy price shock will result in higher inflation and lower growth, and worsen the twin deficits, but what will be the magnitude of these effects? Upside inflation risks are material The inflationary impact appears to be significant. India’s regulated fuel pricing system currently shields consumers from immediate price increases, but this mechanism has limits, and a sustained rise in oil prices will need some of the burden to be shared with consumers. Higher energy costs increase transportation and fertiliser costs and could lead to food price inflation. This is particularly concerning as fertiliser imports from the Middle East have been disrupted. Moreover, a persistent energy price shock could lead to broader price pressures as businesses pass on higher input costs to consumers. We estimate that every 10% increase in oil prices will add 0.5 percentage points to headline inflation, and forecast CPI inflation to average 4.5% in FY27, up from 2.0% in FY26, with risks skewed to the upside. Negative growth shock, but manageable The energy price shock will negatively impact economic growth. The conflict has already led to gas supply curtailments, forcing some industries to reduce production. Heightened uncertainty and lower profit margins may delay investment decisions. However, there are some offsets in place. Prior to the energy price shock, the economy was experiencing robust growth momentum, supported by past policy easing, GST rate cuts, and improved financial conditions. Fiscal policies aimed at protecting consumers from higher energy prices should limit the squeeze on households’ real disposable incomes. The lower U.S. tariff rate and recent trade agreements are also positive tailwinds. Overall, we expect some adverse growth impact but see GDP growth at around 7% in FY27. Fiscal pressures Fiscal pressures are building up. The government has cut central excise duties on petrol and diesel to provide relief. The Centre faces pressure to increase fuel and fertiliser subsidies to shield consumers and farmers from higher prices. We estimate that these could add around 0.6% of GDP to the fiscal burden. These fiscal costs will require offsetting measures such as windfall taxes or spending cuts to meet Budget targets. Twin challenges: Current and capital account Higher oil prices directly increase India’s import bill, with every 10% oil price rise worsening the current account balance by 0.4% of GDP. Moreover, with an increase in the price of coal, LNG and fertilisers, the impact could be more broad-based. At current oil price levels, the current account deficit is likely to widen from less than 1% of GDP in FY26 to more than 2.0% in FY27. The more significant challenge lies in the capital account, where foreign portfolio investment outflows driven by global risk aversion, combined with ongoing FDI repatriation and India’s own outward investment, are creating balance of payments funding pressures. The currency is likely to be the shock absorber in this scenario. Should the RBI be patient? The Reserve Bank of India (RBI) faces a complex policy dilemma, but there are arguments for patience. The current shock is supply-driven rather than demand-driven, suggesting that monetary tightening may not be the appropriate response. Additionally, India’s underlying inflation has remained below 4% for nearly two years now, so the starting point on inflation is more benign. We expect the RBI to maintain its current policy rate in the near term, focussing on managing currency volatility while monitoring for any broadening of price pressures. The central bank’s priority will be ensuring financial stability while avoiding premature tightening that could undermine growth recovery. However, if oil price increases prove persistent and begin to feed into broader inflation expectations, the RBI may need to act to maintain credibility and anchor expectations. Risks and learnings The primary concern at this stage is the potential for a prolonged energy crisis. While India can manage a short-term shock by running down existing inventories, a sustained disruption lasting several months could overwhelm these defences. India must accelerate efforts to diversify energy sources away from the Middle East, build more strategic petroleum reserves, and reduce fossil fuel import dependence through faster deployment of renewable energy. The times are tough now, but every crisis is also an opportunity. (The column was written before the RBI came out with its April monetary policy. The author is Chief Economist, India and Asia ex-Japan, Nomura. Views are personal.)

Iran War Impact: Energy price shock, stagflation risks, and policy trade-offs

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