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Business News/ Opinion / Online-views/  How real is real interest rate?
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How real is real interest rate?

Exact quantum of real rate depends on the state of the economy, but the confusion at this point is about the calculation of real rate

By explicitly linking the real interest rate to the treasury bill yield, RBI governor Raghuram Rajan has made the policy rate more market-driven and created more room for future rate cuts. Photo: BloombergPremium
By explicitly linking the real interest rate to the treasury bill yield, RBI governor Raghuram Rajan has made the policy rate more market-driven and created more room for future rate cuts. Photo: Bloomberg

After Reserve Bank of India (RBI) governor Raghuram Rajan surprised the market by a half a percentage point repo rate cut and his commitment to continue with the accommodative monetary policy in Asia’s third-largest economy, 1.2 billion Indians’ collective obsession with the repo rate has been replaced with “real" interest rate. How much interest should one get from the government’s small savings schemes and how much from bank deposits? What should be the ideal lending rate for banks? And, of course, what should be the ideal repo rate?

Indeed, the exact quantum of real rate depends on the state of the economy, but the confusion at this point is about the calculation of real rate. By definition, the real interest rate is the rate of interest a saver expects to get after allowing for inflation. Going by the so-called Fisher equation, the real interest rate is approximately the nominal interest rate minus the inflation rate. This is fine, but what is the ideal benchmark rate to calculate the real interest rate? Should it be bank deposit rates? If indeed that’s the case, should we allow for income tax that one pays on interest earnings from bank deposits? If not bank deposits, should it be the central bank’s policy rate? Or, the yield of a 10-year bond? One-year treasury bill?

By any yard stick, real interest rate in India was negative in 2013 when inflation was in double-digits for months. In fact, for three years between 2012 and 2014, the average inflation was 8.22%, making the real interest rate negative for most interest earnings for savers. Rajan has been talking about keeping the real interest rate at 1.5-2%, but RBI never clarified how it should be calculated till the 29 September policy document, which says, “The Reserve Bank has front-loaded policy action by a reduction in the policy rate by 50 basis points. Given our year-ahead projections of inflation, this ensures one-year expected treasury bill real interest rate of about 1.5-2.0 per cent, which are appropriate for this stage of the (economic) recovery".

One basis point is a hundredth of a percentage point.

In his conference call with analysts after presenting the December 2014 policy, Rajan had said, “Now where do we see real interest rates go? …it obviously depends on the stage of the cycle and the stage of development… Today, world real interest rates are about between 1.5% and 2%, depending on the country that you go to; I am talking about long-term real interest rates. So my guess is that would be approximately where we would go in the normal phase of the cycle." In the next conference call with analysts in February 2015, Rajan said, “We think that between 1.5% and 2% is a reasonable real rate, given where we are in the business cycle… What we would like is the real risk free-policy rate to be about 1.5% to 2%."

After presentation of the last policy, he explained the real interest rate at the analysts’ conference: “…it was actually at a discussion like this may be few policies ago when somebody sort of asked the question, ‘are you talking about the instantaneous rate, are you talking about the one-month rate, are you talking about the 10-year rate’, and I think the guidance we gave then was it is the one-year treasury rate and the expectations of inflation over the one-year. So, that is why I gave you the calculation at the beginning of this. Just to all be on the same page going forward that is what we can do… The natural rate or the natural real rate is a moving object… It depends on the state of the economy… So, this 1.5% to 2% was something we suggested was appropriate in the recovery stage of the economy... Going forward… I do not think this… is cast in stone, but I think it is appropriate given the current conditions..."

If the real interest rate is calculated on the basis of the central bank’s policy rate, then till the latest round of rate cut, India had the highest real rate among Asian and emerging markets except for Brazil, and even now, this remains the case. How does the scenario look like once we link the real interest rate to one-year treasury bill yield? Typically, one-year treasury bill yield is 25-50 basis points higher than the repo rate. At this point, it is around 40 basis points higher than the repo rate (7.15% versus 6.75%). By explicitly linking the real interest rate to the treasury bill yield, Rajan has made the policy rate more market-driven and created more room for future rate cuts. However, unlike the policy rate, which is determined by the central bank, the treasury bill yield can be volatile as it depends on many factors, including liquidity in the system and foreign funds flow on which RBI may not have an overwhelming influence.

With an imminent drop in the government’s small savings rates, the transmission of policy rate is expected to be faster as the banks will be in a better position to pare their loan rates. This is because they can aggressively cut their deposit rates—something which precedes the loan rate cuts. While the policy rate is now back to the March 2011 level, most banks’ base rate, or the minimum lending rate, is at least 100 basis points higher than the 2011 level.

There is logic in the banks’ argument: they cannot pare their loan rates unless they are able to bring down their cost of money. But one wonders why Indian banks cannot focus on floating rate deposits while their loan assets carry floating interest rates. Even after savings bank deposit rate is freed, all large banks are sticking to the last administered rate of 4%. They don’t care whether inflation is in double digits or sub-4%.

So much for debate on real interest rates!

Tamal Bandyopadhyay, consulting editor of Mint, is adviser to Bandhan Bank. He is also the author of Sahara: The Untold Story and A Bank for the Buck.

Email your comments to bankerstrust@livemint.com. His Twitter handle is @tamalbandyo

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Published: 04 Oct 2015, 07:57 PM IST
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