Monetary policy in the fog: How uncertainty upends central bank strategy
Central bankers are most concerned with radical uncertainty—which makes it nearly impossible to assign probabilities to future outcomes. The current situation is somewhat similar, with US President Donald Trump’s fast-changing tariff policies making it impossible to estimate their impact.
“Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape." — Alan Greenspan, former US Federal Reserve governor, in his ‘Monetary Policy under Uncertainty’ speech in August 2003.
Monetary policy is about making decisions about future interest rates and money supply on the basis of past data.
But 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. This complicates deciding on whether to ease, tighten, or maintain the rate.
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 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%.
When there is no clarity on the future magnitude of key variables, a central bank is likely to respond by easing interest rates and liquidity (RBI’s reaction in 2008-09) or waiting for the situation to become clearer (RBI’s latest October policy response).
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.
Studies show that private investment is particularly vulnerable to uncertainty. Businesses need both low interest rates and a benign risk environment to put up risk capital. The larger the planned capital expansion and the more irreversible the investment, the more likely it is to be deferred until uncertainty reduces.
A stable risk environment need not incentivize corporate investment, but high uncertainty always dampens investment.
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.
For example, if bank credit becomes less important than non-bank sources of funding, then rate cuts may not deliver the expected boost to bank credit. The assumption that growth would be stimulated via bank credit becomes weaker.
RBI faces a similar situation currently: despite monetary easing, growth in bank credit is slowing.
The solution is not more rate cuts. Rather, there is a need to look at developments in the financial system as a whole.
Fortunately, RBI seems to be doing exactly that. The regulator has pointed out that bank lending is sluggish, but non-banking financial company (NBFC) credit and fund mobilisation from the capital market are growing at a healthy rate.
Last week, RBI in its October monetary policy announced measures to ease bank financing for mergers and acquisitions; increase limits for financing IPOs (initial public offerings) and lending against shares and debentures; and improve bank credit access to large corporations.
In other words, rather than exhorting banks to lend more, RBI has widened the bank financing pipeline to enable deeper participation in capital markets.
Communication is the 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.
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.
The author is an independent writer in economics and finance.
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