Post-crisis monetary policy, a balancing act

The first monetary policy committee (MPC) meeting of FY25 started on Wednesday amid slowing inflation and robust growth. An interest rate cut at this stage could overheat the economy, which is growing at 7–8%, and create inflationary pressures. A rate hike could throttle growth, while leaving inflation unaffected owing to factors beyond control. Given such trade-offs, the MPC may leave rates unchanged. In fact, market expectations of rate cuts have been pushed out further in recent months. The Reserve Bank of India’s (RBI’s) latest survey of professional forecasters does not predict monetary easing until the end of the September quarter of FY25.

To understand the shift in market mood, it is useful to go beyond the inflation-growth debate. The “Kaldor magic square” (see chart below) analyses four parameters and provides a more nuanced perspective. An ideal economy would have low inflation, strong growth, low unemployment and a balanced current account. In the Kaldor framework, the ideal economy plots as a square with a large area. Deviations from the ideal show up as distortions in shape, which shrinks the area. Note the smaller, non-square shape representing the economy in FY23, largely due to the twin challenges of unusually high inflation and a relatively high current account deficit. Conditions improved in FY24. But while GDP growth was robust, inflation, unemployment and the current account were not even halfway to that of the perfect economy. Since policy aims to minimize deviations from the ideal, a tight monetary policy was clearly the only option available.

Rate cut expectations have been pushed out in recent months Fiscal Restraint Growth, inflation improved in FY24; there's scope for better on jobs

SOME CLUES about how policy works emerged from the early 2010s, when inflation and the current account were flashing red. There are similarities between then and now: coming after a period of a crisis (global financial crisis in 2008, covid-19 in 2020), steep rate cuts, sharp rupee depreciation, a post-crisis demand rebound, and eventual high inflation. But the impact of monetary policy was quite different. Starting March 2010, the repo rate was hiked by 3.75 percentage points over the next two years. However, inflation remained high, the rupee kept falling, and the current account worsened. In contrast, rate increases have done a better job in the last two years.The key difference? The fiscal stimulus unleashed in 2008 led to a ballooning fiscal deficit, which created its own inflationary pressures. The present fiscal stance is tighter, with spending focused on capital expenditure. This combination of fiscal restraint and monetary prudence is more effective in achieving stability.

Positive growth surprises and declining inflation have boosted market confidence Equity-bond Correlation Positive Surprises

THE MARKET seems to have accepted that interest rates will remain high for longer. This shift is driven mainly by a change in inflation-growth dynamics. Inflation has fallen steadily below the 6% upper limit. Also, inflation has surprised on the downside in the past few months. This is a reversal from 2022, when inflation was high and volatile, and inflation surprises were often positive (actual inflation higher than expected). Low or negative inflation surprises usually suggest that inflation is under control. When inflation is low and stable, the market’s focus shifts to growth, and to the expected policy response to growth data. Since the first quarter of 2023-24, growth has consistently surprised on the upside, giving a huge fillip to equity markets. Simultaneously, expectations of easing have boosted bond prices. Thus, we have a situation where fiscal policy is enabling growth, and monetary policy is controlling inflation. That is a sure-fire recipe for investor confidence.

EQUITY AND bond returns in India tend to be positively correlated, but during crises such as the pandemic returns on them do move in opposite directions. During the pandemic, bond prices rose in response to rate cuts, while stocks fell as risk-averse investors switched to safer assets. In contrast, both equities and bonds did poorly in the first half of 2022, when inflation was rising. High inflation impacts bond valuation in two ways: Real values of coupons decline, and expectations of a rate increase push down bond prices. Share prices also react adversely to inflation, mainly in anticipation of higher interest rates.

Equity-bond returns are again aligned, and that’s good news. A recent RBI study observed that the correlation between bond and equity returns was high and positive particularly during periods of moderate inflation and strong growth. If that is true, market returns now are signalling a favourable economic environment.

The author is an independent writer on economics and finance.

Fiscal restraint is key to the success of monetary tightening Positive link between equity and bond returns signals a favourable macro environment

To represent four metrics on a comparable scale, the annual data for FY17 to FY24 has been normalized to a scale of 0–1 for each metric: the best year is assigned 1, the worst 0, and the rest are linearly interpolated (this assumes that in an ideal economy, all four metrics would have their best reading from FY17–FY24.) The 'square' for FY23 resembles a triangle because inflation that year was the worst during the period, hence collapsing one vertex of the square to the zero point. As a reading gets better, its corresponding vertex moves towards 1. *Based on Apr-Feb figure for inflation and unemployment, and forecasts for GDP and current account. Source: Ministry of statistics and programme implementation, CMIE, Reserve Bank of India