Are India’s policy rates too low?

Ever since it took the bond markets by surprise, when it suddenly tightened liquidity conditions earlier this month, the Reserve Bank of India (RBI) has effectively changed the monetary policy narrative.

Few now expect the Indian central bank to reduce interest rates on 30 July, when it is due to announce its next monetary policy. The overwhelming consensus is that it will hold rates; a few even argue that interest rates should be increased just as other emerging-market economies such as Brazil and Indonesia have, so that Indian bonds stay relatively attractive for global investors. On Tuesday, the central bank withdrew the ₹ 75,000 crore daily repo limit it had put in place earlier this month to defend the rupee, but replaced it with another set of measures to limit liquidity.

The question of what governor D. Subbarao should do next is intimately linked to the question of what the “correct” level of interest rates should be in the first place. A tighter monetary policy after a long period of unusually low interest rates has very different implications from a similar action when interest rates are close to their neutral level, where monetary policy is neither tight nor loose.

One useful way to estimate the desired level of interest rates is based on two sets of data: the output gap and the inflation gap. The former shows the divergence between actual and potential economic growth; the latter shows the deviation of inflation from the level that the central bank targets. The best-known formalization of such analysis is to be found in the Taylor Rule, named after the Stanford University monetary economist John B. Taylor. To be sure, much depends on how the output gap is estimated and which inflation rate is considered. Yet, there is no doubt that the Taylor Rule provides an elegant answer to the big question: what should be the level of interest rate given trends in output and inflation?

Take a look at the chart here. It is taken from a very detailed report released in June by investment bank Nomura, titled Asia’s Rising Risk Profile. The chart shows that India has kept interest rates substantially below what a Taylor Rule would have recommended. Six combinations of output gap and inflation have been considered, which is why a range of interest rates suggested by the Taylor Rule have been shown, rather than a single rate.

The Nomura analysis suggests that central banks across Asia kept monetary policy too loose over the last four years, one reason why economic fundamentals across the region have been deteriorating. The investment bank has also grouped India, Hong Kong and China in the “high-risk danger zone category”. What has put India into this category is its current account deficit, property prices, consumer price inflation and slowing potential growth rate. “The danger zone does not mean that a financial or balance of payments crisis is imminent, but it does mean that, without a move towards less-accommodative macro policies to rein in debt and property markets, and a step-up of structural reforms to boost productivity-enhancing supply, some countries could face a crisis in the next few years,” says Nomura.

A similar analysis by Goldman Sachs released on 18 July comes up with slightly different results as far as India goes. It used the Taylor Rule to show that policy rates seem too low given the economic cycle in many emerging markets. Turkey, Indonesia and South Africa have the clearest case for an interest rate hike. Policy rates in Poland, Hungary and Chile are a little higher than what a Taylor Rule analysis would suggest. India is somewhere in the middle, with interest rates lower than necessary but not by a large margin (though it is significant that Goldman Sachs has used wholesale price inflation rather than consumer price inflation in its analysis of Indian monetary policy).

A little earlier, the International Monetary Fund said in its latest Regional Economic Outlook that was released in April that policy rates in many Asian countries were lower than what was implied by a Taylor Rule. “Asian central banks kept policy rates at low levels or brought them down further in 2012, and many of them continue to buy some insurance against downside risks by maintaining slightly lower policy rates than their past behaviour would suggest.”

The recent moves by the Indian central bank can be reasonably debated only after there is some understanding of whether monetary policy was too loose in the first place. The three analyses cited above—Nomura, Goldman Sachs and IMF—suggest that policy rates have been lower than usual.

But even an analysis based on a Taylor Rule may not give unambiguous answers. However, the combination of a high current account deficit, a weak currency, high consumer inflation and a real estate bubble does suggest that a tighter monetary policy can be a useful form of defence—though the combination of a tighter monetary policy and a tighter fiscal policy will harm growth.

The question policymakers need to ask is this: what is more important right now, economic stability or a stimulus to growth?

Niranjan Rajadhyaksha is executive editor of Mint. Your comments are welcome at cafeeconomics@livemint.com. To read Niranjan Rajadhyaksha’s previous columns, go to www.livemint.com/cafeeconomics