Graphic: Naveen Kumar Saini/Mint
Graphic: Naveen Kumar Saini/Mint

What is the neutral real interest rate?

The real policy rate in India is close to the neutral real interest rate, reinforces the view that RBI will desist from further rate cuts until the end of next year

The Reserve Bank of India (RBI) has said that the neutral real interest rate in India should be 1.5-2% for this stage of economic recovery. This measure is the rate at which desired savings equal desired investments or the rate at which growth is close to potential and inflation is stable.

Why is it important?

As Nomura economists point out, summing up observations from a recent RBI staff working paper, if projected inflation is higher than the inflation target, then the actual real rates must be higher than the neutral real rate to ensure than monetary policy is anti-inflationary. As the chart alongside from Nomura Global Economics shows, the real policy rate in India is close to the neutral real interest rate.

“The RBI study implies that the optimal real interest rates should remain around 1.6-1.8% in 2016 (since inflation will be close to the 5% target), but greater than 1.6-1.8% in 2017, since we estimate that inflation is likely to be higher than the 4% target (by Q1 2018)," wrote Nomura economists in a recent note.

That reinforces the view that RBI will desist from further interest rate cuts until the end of next year.

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