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.