The Reserve Bank of India’s new neutral rate
India’s new monetary policy committee (MPC) met under the new central bank governor for the first time on 4 October, and decided to lower the benchmark repo rate by 25 basis points to 6.25%. It also signalled a more practical approach towards cleaning up bank balance sheets. This was in line with market expectations. First, the central bank had indicated towards the end of the tenure of the previous governor that it had shifted to an accommodative mode. Second, consumer price inflation was trending downward and seemed to be within its comfort zone. Third, the new governor was widely perceived as dovish, with a growth and credit rather than anti-inflationary and financial stability bias, in contradistinction to the former governor.
It may be recalled that the former governor came in for sharp criticism from the treasury benches for his supposed hawkish stance that tilted towards fighting inflation and deteriorating banking assets at the cost of growth. This may well have been the reason why his term was not extended—a departure from past practice, in what appeared to be an infringement of the central bank’s independence. The gold standard in developed markets is that the treasury does not comment on monetary policy.
The easing nevertheless struck a slightly jarring note as the central bank acknowledged obstacles to reaching its inflation target of 4% in the foreseeable future, with the consumer price index expected to stay sticky at around 5% over the next several months, leaving little headroom for further easing. The ostensible reason given for lowering the policy rate despite this upside risk was a downward shift in the target real interest rate from 1.5-2% to 1.25%. The justification was that central banks globally are moving towards lower neutral interest rates. The neutral or equilibrium rate of interest is the policy rate of the central bank when both inflation and growth are on target.
It is widely believed that the US Federal Reserve implicitly followed the Taylor Rule in setting monetary policy. The metrics of this rule is based on a real neutral interest rate of 2%. Its benchmark federal funds rate has, however, been stuck near the zero-bound since the global financial crisis broke out a little less than a decade ago. John B. Taylor has long observed that the Fed had started deviating from his eponymous rule even prior to the global financial crisis. The deviation has not only persisted in the wake of the crisis but has become even more exaggerated. There is now speculation that it is possible that the US Federal Reserve has abandoned the rule altogether. This deviation may well have inflated the credit bubble that burst with the financial crisis. Some argue that continued deviation from the Taylor Rule is fuelling another asset bubble, making another crisis imminent.
There is, however, a counter-argument that Fed policy is consistent with the Taylor Rule, and that it is simply working with a lower equilibrium rate. This fits in neatly with the theory advanced by former Fed chairman Ben Bernanke that the global ‘savings glut’ is putting downward pressure on the neutral interest rate. The extreme view is that the current zero-bound monetary policy in advanced economies is not accommodative enough, and that persistent deflationary pressures in these economies indicate that the neutral interest rate might actually be negative. Some advanced economy central banks, such as those of Japan and the European Union, have indeed flirted with negative rates. The Federal Reserve has not ruled out the possibility of negative rates in the future.
Should India follow the example of advanced country central banks? There are good reasons why it should not. First, although inflation has declined, unlike advanced economies, India continues to have an inflationary rather than deflationary bias, driven by volatile food prices. Second, India has a savings-investment gap instead of a savings glut. Financial savings have indeed been falling. It is true that the savings-investment gap, captured in the current account deficit, has fallen in the recent past. But this is due to the decline in demand, especially investment, and in oil prices. If investment were to revive, and/or oil prices to increase, the gap could widen again. A reduction in the neutral interest rate is likely to lower financial savings further, diverting them to unproductive assets like gold, or less productive sectors like the informal economy.
It could be argued that the US also has a savings-investment gap, reflected in its persistent structural current account deficit. By virtue of minting the global reserve currency, however, there is no difference between the US’ external and domestic debt. It can tap the global savings glut without being penalized by markets. Indeed, the slightest hint of economic or financial trouble pushes capital to the US. Its public debt to gross domestic product ratio has doubled since the financial crisis, yet its cost of borrowing has declined. To a lesser or greater extent, this is true of other reserve currency areas as well.
India too has been tapping the global savings glut to finance its savings-investment gap through large capital inflows. The critical difference, however, is that whereas central bank policies in reserve currency areas, and in particular those of the US Fed, determine the direction of international capital flows, external debt crises and sudden stops of capital are the chief sources of macroeconomic crises and collapse of growth in developing countries. The latter widen their savings-investment gaps at their own peril.
The first action of the new MPC and governor reinforces the belief that there is a weakening of the inflation-targeting framework of the central bank and a movement back towards greater financial repression and credit-fuelled growth. The minutes of the meeting will shortly be made public. These will reveal the rationale behind lowering the policy rate despite its relatively pessimistic assessment of inflationary pressures relative to its target, and also why it felt compelled to follow the precedent set by advanced economy central banks in the matter of neutral interest rates despite apparently different domestic circumstances.
Alok Sheel is a retired civil servant.
Comments are welcome at firstname.lastname@example.org