When Oil Spikes, What Can Policymakers Actually Do?

This is the second part of the article. Part 1 explored how oil shocks travel through the economy, which you can read here.

Sources and references are linked in the article and a glossary of relevant economic terms is given at the end of this article.

In part 1, we explored how oil has a cascading effect on prices of goods and services. This second part explores the policy side of that question – what can policymakers do about imported inflation especially in a country like India which is heavily dependent on imported oil.

India has long been an oil sensitive economy. Be it the Arab oil embargo in 1973-74 or the Gulf War in 1990-91, global oil price hikes have led to imported inflation. Depending on the severity of the situation, the Finance Ministry and RBI step in with structural and policy changes to combat this inflation.

The 1973 crisis, which pushed global oil prices by four-fold, worsened India’s already tight foreign exchange position. FERA (foreign exchange act) had already been under consideration before the crisis; the 1973 oil shock and the resulting strain on foreign exchange reserves accelerated its implementation. The Government also imposed stringent import restrictions. In 1975, the rupee transitioned from a pegged fixed rate to a basket peg rate and this war was one of the factors that caused this change.

The 1990 crisis exposed India’s heavy reliance on imports and forced the Government to bring in the 1991 economic reforms that opened the economy to the world. I have written about its impact on India’s IT industry in my March edition which you can read here.

The current crisis is still in its nascent stage, barely two to three months old. A sustained war may force both the Government and RBI to step in with reforms or drastic measures. In its June 2026 report, RBI did not change the repo rate, it continues to be 5.25%. But it revised the projected inflation rates. For now, the RBI appears to be choosing patience over action.

A temporary fluctuation in prices generally settles down on its own – economists call this phenomenon transitory inflation. In our case, if the war is over soon, the Strait opens and maritime navigation is restored. Brent crude will fall as oil resumes flowing freely through the Strait. The higher maritime risk premium would no longer exist. The market forces would control the imported inflation even without active intervention from the RBI or the Government.

The challenge arises when such high inflation exists for a prolonged period and starts getting factored into wages and prices of services – economists call this phenomenon entrenched inflation. That would require RBI and Government intervention to ensure that inflation does not become a permanent part of daily life and more importantly, does not create a never-ending loop of rising costs.

The authorities have every reason to be worried. Left unchecked, even a seemingly small, steady increase in food prices starts to change how the entire workforce behaves. If food inflation grows unchecked, at hypothetically, say, 5 per cent each year, the cost of living becomes higher across strata. The same income cannot sustain the same standard of living. Inflation pushes up wage demands across every income level — from household help to salaried professionals. Salaries are revised, leading to a permanent change in the economy. This wage revision is termed as wage inflation, and unlike a temporary price spike, it represents a structural, lasting shift in the cost base of the economy. Once salaries are revised, they rarely go back, even if prices drop. That stickiness is what turns a price shock into entrenched inflation. These higher salary costs raise the cost of production and services, which in turn pushes up the prices of goods and services in the economy. This becomes a vicious, never‑ending loop — and it is precisely why RBI is so anxious to keep inflation under control.

RBI: Managing Inflation Expectations

In March 2026, rumours floated on social media that there would be a petrol shortage in India, and we saw long lines of cars waiting at petrol pumps. Whether rational or not, consumer behaviour is to hit the panic button every time there is scarcity, or even just the rumour of it. Imported inflation brings with it price-rise expectations, and once those expectations take hold, hoarding becomes an easy way to either earn quick speculative gains or build a buffer against the price rise people now expect.

The same expectation effect plays out in wages, as we saw earlier — workers anticipating a higher cost of living push for wage hikes today. Hoarding and wage demands are different actions, but they share the same root cause: people acting now on a belief about where prices are headed. In both cases, a supply-side shock starts generating demand-side pressure of its own — and that additional, self-created pressure is exactly what turns a passing price shock into entrenched inflation.

The RBI’s job is to stop that spiral by anchoring expectations around its inflation target. It does this by clearly signalling that it will not allow a temporary supply shock to morph into permanently higher inflation, and backing that signal with its monetary policy tools.

Even though the initial shock comes from the supply side, most of the RBI’s instruments work by managing demand. If the central bank can convince households and firms that it is willing to tighten financial conditions to protect the inflation target, they have less incentive to hoard or push aggressively for wage hikes. Expectations stay anchored, and the second‑round effects of the oil shock are contained.

Repo rate: RBI can increase the repo rate, which is the rate at which it lends short-term money to commercial banks, who in turn lend money to customers at a higher rate. A repo rate hike makes loans dearer and that typically reduces the number of car, home and working capital loans customers are willing to take. An interest rate hike makes savings and fixed deposits more attractive, encouraging people to deposit money with banks rather than spend it. Over time, spending decreases, demand falls and inflation pressure reduces. What looks like a 0.25% move on a policy chart is, in practice, a change in how much you pay every month on your home loan, and whether a business decides to borrow money to expand.

Liquidity measures: Commercial banks are required by law to park a portion of their deposits with the RBI in the form of Cash Reserve Ratio (CRR). Statutory Liquidity Ratio (SLR) is another tool which requires the commercial bank to invest a portion of their deposits in cash, gold or approved Government securities, thus effectively preventing them from lending this money to customers. RBI can hike CRR or SLR when it wants to reduce the money floating in the system, forcing banks to park more funds and leaving them with less to lend. Combined with a higher repo rate, tighter liquidity means banks have less money and costlier money to lend. The elegance of the SLR is that it is not just a liquidity tool, it is also a built-in channel that directs bank money towards Government borrowing. It serves dual purposes for the authorities since it helps RBI control liquidity while the Government secures a steady, lower-cost source of funding.

Open Market Operations: RBI can also sell government bonds directly into the market through auctions. When investors and institutions buy these bonds, they pay RBI in cash, effectively pulling that money out of active circulation in the financial system. Like CRR and SLR, this tightens liquidity, but through a market mechanism rather than a reserve requirement, giving RBI an additional, more flexible lever to manage how much money is chasing goods and services in the economy.

Forex management: The RBI manages India’s foreign exchange reserves, largely held in US dollars and other major currencies. In periods of imported inflation and rupee pressure, it can sell some of these dollars into the market to meet the sudden demand for foreign currency and slow the rupee’s fall. This is one of several forex measures RBI uses to calm markets and reassure investors. This step does not fix the problem but buys precious time to fire-fight using other measures. My third article in this edition covers in depth the INR Dollar jugalbandi during the war – you can read it here.

Finance Ministry: Managing the Immediate Price Pain

While the RBI formulates monetary policy to regulate the flow of money in the economy and actively controls interest rates, the Finance Ministry (Fin Min) designs fiscal policies that direct the flow of money into the real economy. The Finance Ministry’s decisions show up directly in everyday life: an excise duty cut makes petrol cheaper, a tax holiday boosts a chosen manufacturing sector, a fertiliser subsidy reduces farmers’ input costs, and a higher import duty on gold discourages consumption. While RBI mostly sets one rule for everyone — the cost and availability of money — the Finance Ministry can customise its response, changing taxes and subsidies for specific sectors and income groups.

Regulating indirect taxes on fuel: Fin Min controls the price of fuel at pumps and fuel price regulation is largely a politico-economic decision. When crude prices rise, carrying with them the hidden threat of imported inflation, Fin Min can decide whether to pass on the higher prices to the consumers or to sustain the current prices by various measures. For temporary stability, the Fin Min can use the reserve stocks of oil to stabilise the price short term. However, if the threat extends beyond the reserve stock period, then the Fin Min may cut excise duty imposed on OMC to control the costs. Controlling oil cost at OMC level means that the cascading effect of the fuel prices is nipped at source.

Subsidies and targeted support: Farmers are the first link in controlling food inflation costs. When fertilisers are in shortage or expected to fall short, the Finance Ministry will roll out fertiliser subsidies for farmers to contain input costs. Another tool in the Fin Min kit would be to procure commodities directly from the farmers at Minimum Support Price (MSP) and sell this through the PDS. The PDS, more commonly known as the local ration shop, could expand its current offerings to include a wide variety of essential commodities like pulses, oil and sugar. These would be offered at subsidised rates with a fixed quota for every eligible family. This is a targeted support measure to help BPL households manage their grocery bill. The poorest wage earners, are given LPG subsidies similar to DBT scheme for BPL households, so their cooking fuel bill does not spike overnight. In extreme cases, public transport may also be subsidised to ease the burden of daily commuters. Separately, State agencies may aggressively build strategic reserves of essential commodities — as a buffer against future shortages and price spikes.

Direct spending and welfare schemes: To help Government employees combat a high inflation, the Fin Min increases the Dearness Allowance for its employees and pensioners. Of course, such an increase can sometimes work as a double-edged sword because they have the potential to increase spending and spike demand – the very opposite of what is needed to control inflation. In fact, during the 1974 oil crisis, the then Government mandated that half of the additional DA be compulsorily deposited into a special Government run deposit account under the Additional Emoluments (Compulsory Deposits) Act, 1974, which was refunded later with interest.

The Fin Min also uses schemes like MGNREGA to absorb the shock of inflation. It helps the poor rural population get jobs in the local vicinity at guaranteed minimum wages, thereby providing income to the poor to tackle inflationary pressure. The MGNREGA wage rates are explicitly indexed annually to the Consumer Price Index for Agricultural Labourers (CPI-AL) as this policy was designed to establish a minimum wage floor across the rural labour market. In case the Government is unable to provide work within a stipulated time frame, an unemployment allowance is given to these workers. Either way, an enrolled rural worker gets some cash support - either as wages or as unemployment allowance.

This policy helps in tackling ‘distress migration’ – when poor rural labourers migrate to urban cities in search of job. In an oil‑driven imported inflation episode, containing such migration likely reduces extra transport fuel use and urban congestion, which would otherwise add to cost pressures in cities. But the same mechanism that protects rural households can also turn into a double‑edged sword: by revising wage floors and putting cash in workers’ hands, MGNREGA can push up rural consumption and rural wages, adding its own layer to inflationary pressures.

Duties and imports policies: The Fin Min would be looking to partly offset the high oil import bill, in dollars, by encouraging exports and discouraging non-essential imports. With the aim to reduce forex outflow, it can impose stringent import restrictions like increasing the rate of customs duty on commodities like gold and silver. Case in point, on May 13, 2026, the effective import duty on both gold and silver was hiked from 6% to 15%.

To prevent speculative trading, the Fin Min also moved raw silver from free category to restricted category of import: traders can no longer freely import silver and need specific import licenses along with stating the end use of the commodity. Unlike silver, raw gold has not been reclassified from free to restricted, instead licences under specific export‑linked schemes, such as Advance Authorisation, have been placed on it, like capping the quantity of each license to 100 kgs. In extreme cases, the Fin Min could even outright ban certain items of import.

At the same time, not all exports would be encouraged. Bans on exporting certain food commodities can be implemented to avoid scarcity in the domestic markets. Case in point, effective May 13, 2026, sugar has moved from restricted to prohibited category which means all types of sugar including raw, white, and refined sugar cannot be exported till September 30, 2026. The Government could also impose stock limits on traders to prevent hoarding and speculative spikes.

The Fin Min can also reduce GST rates on essential food items to manage how much of a price shock shows up in everyday bills. If the cost of producing or supplying a staple like pulses or edible oils rises, but the GST rate is cut from, say, 12% to 5%, the absolute retail price may still go up — just less than it otherwise would. That makes GST an efficient tool for providing relief to households and managing food inflation expectations, even though it comes at the cost of foregone tax revenue.

Fiscal implications: Every tax cut or duty exemption granted by the Finance Ministry is a revenue loss for the Government, and every subsidy or incentive is an additional fiscal cost. Over time, these choices show up either as higher Government borrowing or as lower spending on previously earmarked projects. Sustained support in the face of a global price shock can deepen an already large deficit on the Government’s books.

Time lags in policy implementation can also blunt the impact of these measures. MGNREGA wage revisions are linked to the CPI‑AL, which is published with a lag after the underlying price movements have occurred; by the time the revised wage takes effect, it may be too late or too small to fully cushion rural households against an inflationary shock.

Beyond Institutional control: Neither RBI nor the Government can stop the war or control global commodity prices. At best, they can buy time and reduce the damage — they cannot single‑handedly prevent every crisis. Every decision comes with a trade off because every economic decision has a price; the real question is not whether there is a cost, but who ultimately bears it — households, firms, or future taxpayers.

Glossary:

Pegged fixed rate: is a system where a country’s government or central bank sets its currency’s value to another stable currency. Instead of letting market forces decide the price, the bank buys or sells its currency to keep the rate steady. In 1973, INR was pegged to British Pound Sterling (GBP). My next article on Bretton Woods has more on this.

Basket peg rate: is a currency system where a nation ties its currency’s value to a weighted group (basket) of major foreign currencies, rather than just one.

Transitory inflation: is a temporary increase in prices caused by short-term problems like supply chain delays or sudden changes in demand.

Entrenched inflation: occurs when consumers and businesses expect higher inflation to persist, causing them to adjust their day-to-day spending and wage-demanding behaviour.

Wage inflation: is the rate at which average employee earnings increase over a period of time. When wages rise, workers have more money to spend, which can cause them to buy more goods.

Repo rate: is the rate at which the RBI lends short-term money to the commercial banks.

Cash Reserve Ratio (CRR): is the minimum percentage of a commercial bank’s total deposits that must be maintained as liquid cash with the RBI.

Statutory Liquidity Ratio (SLR): is the minimum percentage of deposits that commercial banks must hold in highly liquid assets, such as cash, gold, or government-approved securities, before lending to customers.

Minimum Support Price (MSP): is the guaranteed rate at which the Indian government purchases crops directly from farmers. Acting as a safety net, it protects agricultural producers from sudden market crashes and ensures fair profits even during bumper production years.

Direct Benefit Transfer (DBT): is the Indian government’s system to send welfare funds straight to citizens’ bank accounts. Families living Below the Poverty Line (BPL) use this system to get subsidies for food, gas, housing, and pensions without middlemen.

MGNREGA: stands for the Mahatma Gandhi National Rural Employment Guarantee Act. MGNREGA provides at least 100 days of paid, unskilled manual labour every year to eligible adults in rural households. The goal is to give poor families a reliable income and build useful community assets.

Consumer Price Index for Agricultural Labourers (CPI-AL): measures the cost of living for agricultural workers in India. Published monthly by the Labour Bureau, it shows how much prices change for a specific basket of goods compared to a baseline period.