Monetary policy: We live in interesting times for interest rates

In particular, to its six-member rate-setting panel, the Monetary Policy Committee (MPC), which begins its three-day meet on Wednesday.

With the key determinant for rate action, retail inflation, having declined for the sixth consecutive month—it was below 3.2% in April by the Consumer Price Index—and GDP growth at 6.5% last fiscal year, the MPC has a fine line to tread.

Under RBI’s inflation targeting framework, it must keep retail inflation within a band of 2% to 6%, with an eye kept on growth.

Also read: RBI poised to cut rates as India eyes a steady takeoff

The trade-off of growth versus price stability, never an easy one even at the best of times, is particularly problematic when we seem to have the best of both worlds.

India’s economy is neither too cool nor too hot. With growth reasonably robust and inflation below RBI’s central target, this is our own ‘Goldilocks moment.’

In such a scenario, what should the MPC do? It has already cut policy rates twice this calendar year, once in February and then again in April, and infused substantial liquidity into the banking system.

As for spurring economic activity, bear in mind that the rate of interest on loans is only one of many factors in corporate investment and private spending decisions. Cheaper credit is an incentive to borrow, no doubt, but this can be outweighed by other considerations.

The ease of doing business, lack of clarity on the external environment (think of US tariff policy) and the state of domestic consumer demand are all major drivers of investment calls. The odds of making worthy use of money, even if it’s available cheaply, is what it comes down to.

As for a retail sales boost, income levels matter more than loan rates. Taxpayers have a tax stimulus this year, so they may be inclined to spend more than usual, but at lower earning levels, where people’s marginal propensity to consume is higher, consumer demand is driven less by overall GDP expansion than by its distribution.

Also note that monetary policy needs to be forward-looking. Any rate action takes about two-three quarters to work its way through the economy. The MPC, therefore, must take a call depending on where it expects to see both growth and inflation six to nine months ahead and act accordingly.

Also read: Lenders concerned about education loans as US tightens curbs on student visas

Unfortunately, it is impossible to know for sure whether price or growth effects will dominate. While trade turmoil led by US tariffs is likely to raise inflation and slow growth down globally, the extent to which India will suffer similar consequences evades a consensus.

The economy’s momentum from the previous quarter might be strong, but it faces headwinds. Price stability may look durable, but inflation staying tame cannot be assured. Not surprisingly, different central banks have responded differently to the situation they are in.

While some like the Bank of England and European Central Bank have cut rates, others such as the US Federal Reserve and Norway’s Norges Bank have not, opting instead to hold rates steady in the face of uncertainty. ‘Each to its own’ appears to be the motto for central banks around the world.

Also read: Mint Explainer: How RBI's latest rate cut, change in stance impact borrowers, depositors

Our MPC should march to its own tune, guided by an informed reading of evolving growth-inflation dynamics. Whatever call it takes this week on policy rates, let’s hope it’s favoured by luck as well.