Introduction to Monetary Policy
Monetary policy is about making decisions about future interest rates and money supply on the basis of past data. However, the past few months have been a period of unprecedented uncertainty even for seasoned policymakers in India, especially when it comes to determining the direction of the central bank’s key policy rate. Uncertainty because of the US’s steep tariffs on Indian imports and other global and domestic factors have made it tough to predict the trajectory of inflation and India’s economic growth.
Radical Uncertainty
Central bankers are most concerned about radical uncertainty, which makes it nearly impossible for them to assign probabilities to outcomes. For instance, it is impossible to estimate what the US tariff on Indian goods would be by the end of 2025. Assigning probabilities to a range of possible tariff rates would only be guesswork. Similarly, it would be difficult to make effective policy decisions if India’s GDP growth is equally likely to be 5% or 8%. Losing the ability to forecast with reasonable accuracy hits at the very core of policymaking.
The Impact of Uncertainty on Policymaking
The global financial crisis of 2008 is a good example of high economic uncertainty. As the crisis unravelled over several months in 2008 and 2009, it became harder to quantify its impact on India’s growth. That can be seen in the changing growth predictions of the Reserve Bank of India’s survey of professional forecasters. At the onset of the global financial crisis, about 70% of the surveyed experts expected a 7-8% growth rate in 2009-10. By February 2009, the forecasts were widely dispersed: 25% predicted below 5% growth, and 19% estimated that growth would be over 8%.
Transmission Choke Point
Extreme uncertainty also weakens the link between interest rates and the real economy. Faced with uncertain future incomes and profits, consumers and businesses may opt to postpone spending. As a result, rate cuts may not lead to higher investments or consumption. Such a situation seems to be developing currently. Between February and September, RBI’s policy repo rate was cut by 100 basis points. This rate cut has been transmitted almost fully to deposit rates, and to a large extent to lending rates. Yet investment growth has not picked up significantly.
Adaptive Policy Tweaks
By far, the most serious effect of uncertainty is its tendency to upend long-standing relationships between economic variables. Most central banks, including RBI, use predictive models that rely on economic relationships observed over time. But extreme uncertainty can make their models less reliable by changing inter-variable dynamics. Such changes could be a temporary response to uncertainty or reflect structural economic changes: policymakers have to identify which of the two is occurring and act accordingly.
Communication is Key
Even under normal conditions, rate change decisions are made only after much debate. In fact, more than half of the meetings of RBI’s monetary policy committee have ended with no rate action. When rates are cut or hiked, 25-basis-point steps are the most common; a jumbo rate cut—say, 50 bps or larger—is usually deployed to manage a crisis (March 2020, pandemic) or forestall a potential crisis (June 2025, US tariff shock). And when conditions are uncertain, it is even more important to tread cautiously.
Conclusion
RBI will probably revise its forecasts as new information becomes available. An honest assessment of the space available for future policy actions (none, limited, or plentiful), along with an explanation of the risks to growth and inflation is more valuable than actual forecasts. A monetary policy statement that recognizes uncertainty while emphasizing price stability and growth support can reassure markets. Ultimately, clear, consistent and data-backed communication is the best defence against uncertainty.
