Making sense of RBI’s interest rate policy
Most private sector economists were predicting that the Reserve Bank of India (RBI) would cut interest rates in December. The minutes of the monetary policy committee that were released last week have sent them back to the drawing board. A majority of the committee members seemed concerned about the sharp acceleration of inflation from the lows touched in June. There are now strong doubts that a rate cut is inevitable before this year ends.
The Indian central bank has come under a lot of fire for misreading the inflation situation, and slashed its inflation forecasts in June, though it must also be said in defence of RBI that it was blindsided by the impact of demonetisation on prices. One important element in the flexible inflation-targeting framework is that the inflation forecast is the intermediate target of monetary policy. In other words, monetary policymakers need to look ahead at where inflation will be a year from now rather than look behind at inflation in the past. The reason they do so is that monetary policy works with a lag of three-four quarters, so a rate decision today cannot change inflation today (and definitely not yesterday) but rather a year down the line. Getting the inflation forecast right is thus essential.
The problem is not with the RBI alone. Most central banks have struggled to get their inflation forecast right in recent years. For example, US Federal Reserve chairperson Janet Yellen said during a speech in September: “My colleagues and I may have misjudged the strength of the labour market, the degree to which longer-term inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation.” Even the European Central Bank has struggled to get its inflation forecast right. Inflation has foxed a lot of people over the past few years, including the professional forecasters polled by the RBI, but too many critics of Indian monetary policy cite the latest inflation number rather than their own inflation forecast to make their point.
Another issue that is inadequately dealt with in the ongoing raging battle on Indian monetary policy concerns the equilibrium interest rate. What is the level of real interest rates at which the Indian economy can grow at potential while meeting the inflation target? Why does this matter? An estimate of future inflation plus the equilibrium real rate can give us a quick idea of whether interest rates are at the correct level.
Pronab Sen writing in The Indian Express and Sudipto Mundle writing in Mint have brought this key issue into the public debate. Sen says the desired real interest rate in a developing country such as India should be around 4%. Mundle cites the 1985 report of the Sukhamoy Chakravarty committee to suggest that the desired real interest rate in India should be 1%. The RBI itself had earlier said that the equilibrium real interest rate in India was 1.5-1.8%, but it subsequently brought that down to 1.25%. It’s obvious there are no easy answers here.
There are two underlying issues that deserve attention. First, a lot depends on what framework is used to estimate the desired real interest rate. One approach is derived from the idea of social discount rate first put forth by the brilliant polymath Frank Ramsey, or the rate at which a society discounts the future to arrive at present values. The social discount rate is used in climate change studies as well to calculate the current value of the costs of future climate change. It can be used to estimate the desired real interest rate as well.
The other approach owes a lot to the idea first put forth by the Swedish economist Knut Wicksell on what he called the natural rate of interest at which prices are stable. A country will face inflation if interest rates go above the natural rate while it will have to deal with deflation if the opposite happens. The Wicksellian natural rate is the origin of the neutral interest rate that is plugged into the ubiquitous Taylor Rule that many contemporary economists use to analyse monetary policy. A lot then depends on whether an estimate of the equilibrium interest rate is derived from the Ramsay approach or the Wicksell approach.
Further, the equilibrium interest rate is not a fixed number. It depends on the trends in potential output. A higher level of potential output will make investments more attractive while at the same time encouraging households with rational expectations to consume more in anticipation of higher incomes later. This combination of higher investment and lower consumption will push up the real interest rate. A lower level of potential growth will have the opposite effect, which is why there is a robust debate in the developed countries on whether equilibrium interest rates have declined since the financial crisis.
Modern central banking depends heavily on unobserved variables, or estimates of future inflation, potential growth, the output gap and the equilibrium real interest rate. The very fact that these are estimates mean that debate is inevitable, especially in the early days of the flexible inflation-targeting regime. It was easier to get a consensus when the intermediate target was a simple one such as the annual growth in broad money, or M3. The Indian debate on interest rate policy is currently suboptimal because not enough attention is paid to these unobserved variables. In that sense, economists such as Sen and Mundle have done well to shift the debate to more solid ground.
Niranjan Rajadhyaksha is executive editor of Mint.
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