To lower rates in a bold or measured way is a classic dilemma of monetary policy

Against the backdrop of trade frictions, sudden movements in the prices of financial assets and growing geopolitical tensions, the minutes mention the word “uncertainty" as many as 16 times. The word “certainty" has six mentions, and that too mostly in the context of uncertainty; for example: to “provide some certainty in the times of uncertainty."

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How monetary policymakers should respond  to uncertainty is a tricky question, as much art as science. The main issue is how monetary policy should be crafted by a central bank when the impact of its policies on the economy is even less predictable than usual. In other words, when  it is unclear how firms, consumers and financial markets will respond to changes in interest rates,  as is often the case when an economy is being  battered by exogenous shocks such as military or trade wars. 

This leads to what is described as “parameter uncertainty," which lowers the efficacy of the forecasting models used by central banks to peer into the future.

Three of the most important examples of parameter uncertainty are the slope of the Phillips Curve, the level of the natural rate of interest and monetary transmission. 

The Phillips Curve gives economists a sense of how inflation will respond to a change in the rate of economic expansion. The natural rate of interest is an anchor that modern central bankers use to gauge whether their policy is in tune with the state of the economy. Monetary transmission tells us whether changes in the policy interest rate are filtering down to actual borrowing costs.

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Economists have been divided into two camps on the issue of how monetary policy should respond to heightened uncertainty because of exogenous shocks to the economy. One view is that policymakers should be conservative when there is uncertainty in the air. The classic statement of this approach is the Brainard Principle, based on a 1967 paper by American economist W.C. Brainard, who argued that central bankers with limited information should be cautious when it is unclear how a policy change will affect the economy.

In March 2019, Mario Draghi of the European Central Bank said: “You just do what you think is right, and you temper, however, what you are doing with a consideration there is uncertainty. In other words, in a dark room, you move with tiny steps." He was articulating the Brainard Principle.

The second approach is diametrically opposite to conservatism. In a 2004 paper that surveys the implications of uncertainty for the design of monetary policy, C.A. Walsh of the University of California at Santa Cruz cites work by other economists that shows how “it will pay to make sure current inflation is very stable by reacting more aggressively to shocks."

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Divergent views on monetary policy action in times of heightened uncertainty matter in the current situation. The tricky choice of whether to be cautious or bold is a useful way to frame the MPC’s latest decision—in a five-to-one vote—to cut policy interest rates by 50 basis points rather than do it in two steps, as most analysts in financial markets had expected. Saugata Bhattacharya was the only MPC member who voted for a rate cut of 25 basis points. He said that “a measured and cautious progress in policy easing is more appropriate at this time."

The five members who voted in favour of the 50 basis points cut made several points in favour of a decisive move, but what was common in their views was that such a big step would give a clear signal to the private sector economy that the Indian central bank is serious about supporting growth against a backdrop of benign inflation.

The underlying calculation is that consumer spending, corporate investment and bank lending would get jolted out of a “zone of inaction," as Rajiv Ranjan noted. The case for bold action was stated by RBI Governor Sanjay Malhotra: “It is expected that the front-loaded rate action along with certainty on the liquidity front would send a clear  signal to the economic agents, thereby supporting consumption and investment through lower cost of borrowing."

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Finally, Ram Singh asked an important question about the neutral interest rate, which is the real rate of interest consistent with an economy that is growing at its potential while inflation remains near target. The neutral interest rate is not only statistically difficult to estimate, but could also change with the state of the business cycle.

Ram Singh estimated that the neutral interest rate in India had increased from 1.2% to 1.65% because of the rise in public debt and pent-up demand after the covid pandemic. This rate has probably come down now. 

The upshot: Is it time for economists at RBI  to provide new estimates of the neutral rate of interest in India now?

The author is executive director at Artha India Research Advisors.