Cut the confusion 

Cut the confusion 

Context

Decisions taken by the Monetary Policy Committee (MPC) have recently attracted a lot of attention. The renewed focus on monetary policy has arisen due to a few factors

Key equation

Real interest rate = Nominal Interest rate – Inflation

Repo rate cut is too little

Author states that repo rate cut by Monetary Policy Committee has been too little because inflation has declined gradually over past few years while repo rate cuts have not matched its decline leading to a rise in real interest rate

A rise in real interest rate causes slowdown in growth because of lower borrowings

Neutral real rate

Author points out that the very statement that the real rate is too high or too low presupposes the existence of some neutral real rate. What is the neutral real rate and how does one determine it?

• Economists call this neutral rate the natural rate of interest. It is defined as the rate at which the country’s output is at its potential level and inflation is stable
• measuring this rate is difficult because it is not directly observed but needs to be inferred 

Measurement of Neutral real rate

• Method 1: compare the real rates across countries
  • Flaw: That strategy, however, is fundamentally flawed since each country is unique in terms of its economic fundamentals and stage of development
  • Thus, the real rate in India, which is still growing at one of the highest rates in the world, cannot be compared with real rates in slower-growing developed economies or other developing countries that are at a different stage of their development process. One needs a different approach
• Method 2: Interest rates are a key input into our saving decision.
  • When we save, we give up goods and services that we could have consumed instead. Since we all tend to prefer consuming today to tomorrow, we need to be compensated. That compensation is the interest rate offered on our saving.
  • Economic theory predicts, to a first approximation, that the real interest rate should equal the growth rate of real consumption plus the rate at which we discount tomorrow relative to today
• Method 3:  Another method to measuring the natural rate is to examine the demand side of the market.
  • Firm owners demand funds to invest in capital.
  • Economic reasoning suggests that the interest rate that they are willing to pay for this borrowing should be related to the productivity of the additional capital that they invest in net of other costs such as depreciation of capital and taxes.
  • Based on data on capital stock, output and depreciation rates on capital available from the latest version of the Penn World Tables, this approach yields a 10-year moving average of the implied real rate between 2000 and 2014 (the last year for which the data is available) at also around 6 per cent, similar to the one derived from the other approach

What does this measure of the natural rate reveal for India?

The 10-year moving average of real consumption growth in India has averaged around 5.5 per cent since 2007. This would indicate that the natural rate of interest in India is around 6 per cent 

Significance

The natural rate in a fast-growing economy like India is extremely unlikely to be below 3 per cent. This point is only strengthened by the fact that the expected real interest rate based on the difference between the repo and expected inflation (as measured by the RBI’s household inflation survey) is even lower

• The stance of monetary policy has to be judged by comparing the real rate with the natural rate. By this standard, the stance of monetary policy in India is still very accommodative.