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. First, the last few years have been marked by slower GDP growth as compared to the growth rates achieved till 2014. Second, there is a general awareness that the room to use fiscal policy, which is the other standard policy lever, may be somewhat limited due to concerns about large fiscal deficits.
Between January 2015 and December 2017 the RBI/MPC reduced the repo rate from 8 per cent to 6 per cent. These rate cuts, however, have attracted criticism on account of being “too little”. The criticism is centred on the fact that the fall in the inflation rate over the past couple of years has implied that the real interest rate, which is the difference between the nominal (or rupee) interest rate and the inflation rate, has risen as a result. The argument then is that the growth slowdown, for a major part, is due to the high real interest rates induced by the stubbornness of the MPC in not reducing the repo rate. Indeed, the implied real rate since October 2016, based on the average of the year-over-year monthly CPI inflation rates, has averaged around 3.9 per cent.
The very statement that the real rate is too high or too low presupposes the existence of some neutral real rate. Just because the actual real rate has risen doesn’t necessarily imply that it is “too” high relative to the neutral rate. But 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.
While the definition of the natural rate seems intuitive and simple, measuring it is difficult because it is not directly observed but needs to be inferred. One temptation is to compare the real rates across countries. 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.
Measuring an unobserved variable is precisely where a little bit of economic theory becomes useful. 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. Importantly, what matters for the saving decision is the real interest rate, not the nominal rate, since we care about the additional goods and services that we can consume tomorrow if we forego consuming them today. 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.
What does this measure of the natural rate reveal for India? Consumption growth can fluctuate from year-to-year. So, to get a long-term perspective on the real rate through the consumption growth rate, one needs to take long averages. 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. The highly correlated movements of consumption and GDP in India also suggest that international capital flows are of relatively second order importance for the consumption dynamics in India. For the purposes of comparison, the corresponding measurement for the US would give a real rate of around 1 per cent.
An alternative way of 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.
While one may disagree with the estimates of the natural rate given above, the more general point is that 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.