Central bank credibility is key to achieving a Goldilocks economy

Source: The post is based on the article “Central bank credibility is key to achieving a Goldilocks economy” published in “Mint” on 29th June 2023. 

Syllabus: GS 3 – Indian Economy 

News: To uphold its credibility, the Reserve Bank of India (RBI) should strive to achieve its 4 percent inflation target while accurately estimating India’s real equilibrium rate of interest. (The RBI decided to leave the repo rate unchanged at 6.5 percent). 

Why is central bank credibility important? 

Central bank credibility is important, particularly in steering an economy after a shock such as a financial crisis or a pandemic.  

Central bank credibility makes disinflation more manageable, and the interest rate increases needed to stabilize inflation expectations are less severe. 

Why is there a two-percentage point band on either side of the target of 4.0 percent? 

It ensures that the RBI does not overreact to the short-term inflationary pressures of temporary supply shocks and maintains a medium to long term view while conducting monetary policy.  

While it gives the RBI operational freedom in the short run, the mandate over the medium term is to keep inflation near 4 percent.  

Sticking to this mandate ensures monetary policy credibility. 

What will be the impact of RBI’s efforts to bring inflation close to the target of 4.0 percent? 

Maintaining the current level of interest rates for an extended period will impact economic activity negatively during a period when the Indian economy is growing at a steady rate, neither too fast nor too slow.  

The consecutive increases in the repo rate have brought the real interest rate close to equilibrium levels and have also anchored inflation expectations.  

However, as anticipated inflation declines, it is important to ensure that the real repo rate does not rise excessively. 

Why is estimating the equilibrium real interest rate challenging? 

The ideal real interest rate in an economy depends on various interconnected factors, including savings behaviour, investment activity, demographics, and potential growth rate. 

However, estimating the equilibrium real interest rate is challenging as it is not directly observable. Additionally, the estimate of the equilibrium real interest rate can change over time.  

Economists from the Bank of International Settlements have suggested that the central bank’s actions can influence the real equilibrium interest rate, which is commonly believed to be beyond its control.