Rate cut amid strong growth signals that monetary policy needs good data

The Reserve Bank of India’s (RBI) policy rate cut on December 6 took many analysts by surprise. It came just after the government reported that the economy was growing at a staggering rate of 8.2 per cent. According to the standard macroeconomics playbook, when an economy is growing so fast, central banks are expected to tighten monetary policy — meaning they raise rates pre-emptively — to control inflationary pressures and stop the economy from growing too quickly.

 

This time, however, the situation was different because inflation has been running at less than one per cent. This comfortable price environment gave the RBI the flexibility to lower rates but it does not automatically justify such a move. The core dilemma remains: Why provide further stimulus to an economy that is already booming at an 8 per cent growth rate?

 

Does this mean the RBI’s policy decision was misguided? Not really. Rather, the rate cut becomes perfectly understandable when viewed through the lens of the policymakers’ primary dilemma: The need to guide the economy while navigating through a thick statistical fog.

 

Let us begin by examining the gross domestic product (GDP) data itself. Official figures suggest that growth is soaring, far above last year’s estimated growth rate of 6.5 per cent. On the surface, the expansion appears broad-based and robust, with the manufacturing and services sectors each growing at 9 per cent.

 

The problem, however, is that these numbers are hard to explain. Some commentators have suggested the cuts in goods and services tax (GST) rates boosted consumer spending, thus raising GDP. But this is unlikely: The tax cuts started on September 22, too late in the July-September quarter to significantly affect the data. Could other key indicators help provide a clue? Not really. In fact, they raise further questions.  

 

For example, industrial output grew by only 3 per cent during April-September 2025. This is the slowest growth since the pandemic year of 2020-21. The core sectors of mining, manufacturing, and electricity showed slower growth or even contracted.

 

Bank credit growth also suggests a weakening economy, with non-food credit — a proxy for credit demand, slowing to 10 per cent in the July-September period from a growth rate of 13 per cent in the previous year.

 

Perhaps most worrisome, tax collections have decelerated dramatically. During April-September, the central government’s gross tax collections grew by only 2.8 per cent, the slowest pace in 15 years. Income, corporation tax, and GST all grew in low single digits.

 

Finally, it is hard to square strong growth with the weak rupee. The Indian rupee has depreciated by more than 6 per cent against the US dollar this year, making it the worst-performing currency in Asia. While external factors have hurt exports, the current account deficit remains modest at less than 2 per cent of GDP and should, therefore, be easy to fund. But this has not proved possible, thereby putting pressure on the rupee. Capital inflows have remained feeble, and oddly enough, have weakened further after the GDP news was announced. The inability of the fastest-growing country in the world to attract capital seems quite an anomaly.

 

In short, it is hard to know how the economy is truly performing. What does this mean for policymaking?

 

For the RBI, it makes its job very difficult. To target inflation effectively, the RBI must set interest rates based on its inflation outlook. But if it cannot reliably assess the real strength of the economy, how can it accurately forecast future inflation?

 

It is true that all central banks find it hard to forecast inflation because food and fuel prices are volatile. They usually fix this by basing their forecast on core inflation, which leaves out these volatile items. However, the situation becomes harder for the RBI when it cannot even forecast core inflation, because it cannot properly judge the underlying strength of the economy.

 

In such circumstances, policymakers have to adopt an approach based on managing risks. The RBI likely worried that collapsing inflation was causing real interest rates to rise. This, in turn, could severely harm the economy if demand was actually weak. On the other hand, cutting the nominal interest rate would not threaten the 4 per cent inflation target, even if demand turned out to be strong, simply because inflation is so low right now. Therefore, the RBI cut rates. For the same risk-based reason, the government also reduced GST rates.

 

Both policy decisions were reasonable, but a large problem remains: They may prove wrong if it turns out that demand is, in fact, quite strong. Meanwhile, the inability to come up with accurate macroeconomic forecasts has already confused financial markets. This confusion has potentially weakened policy credibility, creating further problems.

 

For all these reasons, it is imperative to resolve the data issues. The good news is that the National Statistical Office will soon release updated GDP and consumer price index (CPI) series. We can only hope that these new numbers will mark a significant improvement. Until they do, monetary policy will remain constrained by this data uncertainty.

         

The author is associate professor of economics, IGIDR, Mumbai. The views are personal