The MPC Is Flying with a New Instrument Panel

Monetary policy is challenging even at the best of times. Unlike fiscal policy, which can be much more targeted and has a variety of instruments at its disposal, monetary policy has a limited set of instruments which tend to be blunt. These include policy rates and liquidity management. Furthermore, these policy tools take time to percolate through the economy via various channels such as the banking sector, money markets, and bond markets. Hence, there is always a risk of monetary policy falling behind the curve.

In addition to these fundamental challenges, this year has been particularly difficult for central banks globally. The volatile global environment is a result of political decisions which can change in a short period of time. This was seen in the case of both tariffs as well as the West Asia crisis. Domestically, the monsoons are expected to be a source of volatility with their impact on food inflation and rural demand.

In such a dynamic environment, monitoring the impact of supply-side shocks in real time, as well as forecasting their impact, is important.

Data Complexity
This year, the base-year revision of important data series such as GDP, CPI, IIP and WPI adds another layer of complexity. Whenever there is a base-year revision in a series, it is associated with methodological changes as well as expansion of coverage of items, in line with current production and consumption trends. This results in limited back-dated history of the new base series, as newer surveys and items are incorporated.

This impacts estimation of potential GDP growth and neutral real rates, which require a long history for estimation. From a monetary policy perspective, these two variables are important guideposts when it comes to the policy outlook. If the economy is growing above potential, then there is a risk of overheating, necessitating tightening of monetary policy. Similarly, if real policy rates are below neutral real rates, it implies that monetary policy is expansionary. These uncertainties in estimating potential growth and neutral real rates are well known and persist even when policymakers have access to history. Simple things such as a change in estimation methodology or the time period of study considered can alter the outcome.

Hence, to overcome this, monetary policy looks at the symptoms of disbalance rather than estimating where the equilibrium lies. The characteristics of an economy growing above potential are elevated core inflation and a high current account deficit. Currently, the Indian economy is exhibiting low core inflation and a low current account deficit, clearly indicating a low risk of overheating. Hence, at the current juncture, monetary policy tightening is not warranted as excess demand isn’t the issue.

That said, looking at current symptoms of disequilibrium may not be enough as monetary policy needs to be forward-looking. As mentioned above, policy changes have transmission lags, such as interest rate changes, which take around two quarters to impact the economy. Hence, forecasting growth and inflation is equally important while making policy decisions. Now, due to the base-year revision, the history available for GDP is limited to four years and CPI to less than two years. For econometric models, longer time periods are required to estimate models. Even simple models based on seasonal patterns require longer time periods of data, at least three years.

Forecast Gaps
The forecasting record for 2025–26 illustrates the difficulty. CPI inflation averaged 2.1%, compared with the 4.2% forecast by professional forecasters at the beginning of the year and the RBI’s estimate of 4.0%.

Most of 2025–26 was covered by the old CPI series, so the availability of historical data was not the main problem. Crude oil prices were also relatively stable. The principal source of uncertainty was US tariffs, which ultimately proved much less disruptive than initially feared.

A similar divergence was visible in economic growth. Real GDP expanded by 7.7% in 2025–26, compared with the 6.5% projected by both professional forecasters and the RBI at the start of the year. The revised GDP series came into effect during the second half of 2025–26.

In 2026–27, the degree of difficulty has increased. Policymakers must work with limited historical data while the economy absorbs successive supply-side shocks, including volatile crude oil prices and weather fluctuations.

Early signs of forecast divergence are already visible. CPI inflation in April–June 2026–27 was 3.9%, below 4.1% estimated by the RBI and 4.0% estimated by professional forecasters.

The RBI expects GDP growth of 6.6% in April–June 2026–27, while professional forecasters expect 6.5%. Yet high-frequency indicators such as industrial production, tax collections and listed-company results point to greater resilience and suggest that growth could be closer to 7%.

So, what can the RBI do when its view of the economy is being clouded by base-year revisions and recurring supply shocks?

In many respects, the MPC has already incorporated this uncertainty into its reaction function. It has avoided firm forward guidance and shifted towards taking decisions on a meeting-by-meeting basis.  The Governor has indicated that monetary policy would respond if price pressures became generalised, meaning that inflation in food and fuel began spreading to core items.

The RBI’s reaction function has consequently become more patient. Rather than act in anticipation of a forecast shock, it is waiting for evidence that price pressures are broadening.

That approach increases the possibility that monetary policy may occasionally respond late. But it also reduces the risk of tightening in response to a supply shock that does not persist or spread across the inflation basket. Given the recent gap between forecasts and actual outcomes, the trade-off currently favours patience.