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 "RBI, Reserve Bank of India")
Mumbai: A security personnel stands near the RBI headquarters, in Mumbai, Friday, June 7, 2024. (Photo: PTI)
A Reserve Bank of India study has estimated the neutral rate of interest in India to be between 1.4 to 1.9 per cent for the Jan-March quarter of the financial year 2023-24, which is a sharp upward revision from the previous estimate of 0.8-1.0 per cent for the Oct-Dec quarter of 2021-22, sparking off a debate if the central bank can cut the policy repo rate.
The report pointed out that updating the estimates of the natural rate of interest for India with post-pandemic data found an upward shift driven by the growth of potential output.
“With headline GDP growth rates trending higher after the pandemic, a step up in the natural rate estimates appears appropriate,” said Aditi Nayar, chief economist, ICRA.
Economists measure the real interest rate in the economy as the repo rate minus the one-year ahead inflation. At present, the repo rate is at 6.5 per cent, while average inflation for the fourth quarter is estimated at 4.5 per cent.
The RBI study clarified that the estimate on the neutral or natural rate is centred in wide bands of uncertainty, warranting careful interpretation in the assessment of the monetary policy stance.
The report is authored by Harendra Kumar Behera from the Department of Economic and Policy Research (DEPR), RBI. The views expressed in the article are those of the author and do not represent the views of the RBI, it was clarified.
Behera acknowledged that for India, estimating the natural rate becomes particularly challenging in view of significant structural transformations and demographic shifts.
“In particular, pandemic-induced complexities have altered estimates of potential output and profoundly impacted inflation dynamics,” the report said.
“In its Wicksellian origins, the natural rate of interest is associated with an economy operating at full capacity without generating inflationary pressures,” it said.
Observing that the range is wider than the previous estimate, Gaura Sen Gupta, economist with IDFC First Bank, said, “The lower range of the neutral rate indicates space to cut interest rates by 50 bps in FY25, while the upper range indicates no space to cut interest rates. Given the wide range of the neutral rate, it supports the viewpoint of the dovish external MPC members as well as hawkish RBI members.”
“We maintain expectations of a shallow rate cut cycle starting from October/December,” she added.
Two external members of the monetary policy committee – Ashima Goyal and Jayanth Varma – had voted for a repo rate reduction of 25 bps and a change in stance to neutral in the previous monetary policy committee meeting in June, which was against the majority view of maintaining the status quo on both rate and stance. Both Goyal and Varma said the neutral rate should be around 1 per cent.
“The inference is that with the potential output rate increasing significantly in the country, the natural rate of interest or real interest rate would also be rising commensurately,” said Madan Sabnavis, chief economist, Bank of Baroda. “It would also indicate that the current level of 6.5% repo rate and 4.1% inflation rate is within this band and does not call for policy action,” he added.
Commenting that the difference between the real policy interest rate and the natural rate measures the monetary policy stance, the report said when the policy rate is set below the natural rate, the stance is regarded as accommodative, and the converse signifies a restrictive stance. The policy stance is neutral when the real policy rate is at the level of the natural rate.
In a recent media interaction, RBI governor Shaktikanta Das downplayed the debate around the neutral rate, as he said such an estimate is subject to uncertainties and policy making should not be driven by a theoretical construct.
“Policy making has to be driven not by an abstract theoretical construct but by actual numbers,” Das had said.
First Published: Jul 18 2024 | 8:32 PM IS
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