A growing clamour for interest rate cuts has been one of the highlights of Raghuram Rajan’s tenure as Reserve Bank of India (RBI) governor. While his detractors accused him of stifling India’s economic growth by refusing to lower interest rates, Rajan himself has argued on more than one occasion that real interest rates (policy rate minus inflation) in India are much lower than in other major economies.
In a speech delivered in late July, Rajan argued that India’s real interest rate, i.e. adjusted for inflation, is not high even when compared to other countries in a generally low-interest rate world. The chart presented by the RBI governor showed that India’s real interest rate, which is 0.73%, arrived at by deducting 5.77% inflation from the 6.50% repo rate, is one of the middle values among a set of 26 major economies. In contrast, China, another similar high-growth economy, with an inflation of 1.8% and an official lending rate of 4.35%, has a higher real interest rate of 2.55%. This, he suggested, indicates that RBI’s policy is not too tight.
So, has Rajan’s interest rate regime been hawkish or prudent? Comparing India’s policy rate with the Taylor rule-implied policy rates could help us answer the question.
The Taylor rule—an interest-rate forecasting model devised by economist John Taylor—gives policy rate prescriptions after taking into account the difference between targeted and actual inflation and potential and actual output growth. It will give a higher prescribed rate if inflation is higher than targeted inflation and output growth is above potential output growth.
The Taylor rule-implied policy rate for India has steadily risen in recent months, given the recent rise in inflation, and it says that the appropriate short-term interest rate for India now slightly exceeds the current policy rate of 6.5%, under different assumptions. (More on this later)
Before Rajan came to RBI, policy rates were way below Taylor rule estimates. While Rajan did keep rates above Taylor rule-prescribed values for a brief while, the recent upswing in inflation leading to Taylor rule rates going above policy rates, has vindicated his cautious approach towards slashing rates. The upshot is that Rajan’s policy rate regime has been prudent, and not hawkish as is alleged by his detractors.
Caution must be exercised while drawing too many inferences about the previous years, especially 2013 and 2012 because inflation targeting, based on retail inflation, was only adopted in March 2015. More importantly, inferences for mid-2013 might be misleading because for much of the time the marginal standing facility (MSF, the rate at which banks can borrow overnight funds from RBI against some government securities) rate gained much importance, when it was raised to 10.25% by the then governor D. Subbarao, 300 basis points (bps) above the policy rate, in light of global market volatility and the sharp fall in the rupee. One basis point is one-hundredth of a percentage point. For perspective, the current gap between MSF and the policy rate is a much lesser 50 bps. Thus, RBI’s policy was effectively much tighter in mid-2013 than what the chart above depicts.
Nevertheless, the Taylor rule is a fair method to judge RBI’s policy in more recent times, especially since the adoption of inflation targeting in March 2015. Thus, the conclusion from the Taylor rule is not very different from an examination of real policy interest rates across the world. The rule suggests that RBI’s policy is not too tight and there might not be room for further interest rate cuts.
However, one could argue that RBI’s deviation from the Taylor rule is very small when compared to other major central banks. RBI’s current policy rate appears to be short by 70 to 150 bps of the Taylor rule-implied rate, depending on the set of assumptions while applying the rule. By contrast, other selected major economies show much greater deviation on the lower side, i.e. they are maintaining interest rates much lower than what would be suggested by the Taylor rule (chart 2). This is especially true for the four major central banks of the developed world—US Fed, Bank of England, European Central Bank and the Bank of Japan – with an average shortfall of 250 bps from the Taylor rule.
In fact, the US Federal Reserve has often come under criticism from some quarters for maintaining interest rates much below that suggested by the rule and that too for a long period of time. The current US policy rate of 0.5% is way below the 2.6-3.8% interest rate range suggested by alternative estimates for the US Taylor rule (chart 3). The US has refrained from raising interest rates quickly, despite a steady fall in the unemployment rate—now at 4.9%, even below the deemed natural rate of unemployment of 5%—and despite a gradual rise in inflation since early 2015. Of course, various measures of US inflation still remain near 1%, below the 2% target, thereby apparently justifying low interest rates. But the Taylor rule suggests that even at current levels of inflation, the US interest rates are too low.
Meanwhile, the advanced economies have undertaken additional monetary easing, apart from keeping interest rates low, often through asset purchases, especially bonds. Such easy monetary policy by the advanced economies has often been dubbed as unconventional monetary policy (UMP). Not only advanced economies, even most of the emerging market economies too have maintained policy rates below the levels implied by the Taylor rule for most of the period since the early 2000s, as was noted by a 2012 research paper published in the BIS Quarterly Review.
Thus, some observers might be tempted to conclude from the above reading of the Taylor rule that since most major economies today maintain interest rates much lower than what the Taylor rule would suggest, the incoming RBI governor or the Monetary Policy Committee (MPC) should also follow suit and cut interest rates further.
Such competitive monetary easing might yield temporary results but could do a lot of harm in the longer run. If all countries followed such a policy of competitive easing, then the world risks descending into a series of “musical crises", as noted by outgoing governor Rajan himself in a 2015 speech. Excessive monetary easing, which often leads to exchange rate depreciation in the country that lowers rates, tends to shift demand from other countries to it. Thus, competitive monetary easing does not solve a crisis; it merely transfers it from country to country and is liable to be detrimental to global financial stability in the long run.
Thus, there might not be much room for further interest rate cuts. This is in line with the thinking of most economists who believe that there is space for at most another 25 bps interest rate cut, maybe in the current fiscal year itself. Going forward, in the next fiscal year , RBI might find it difficult to lower interest rates any further amid inflation concerns. However, this does not mean that RBI’s policy will turn from accommodative to tight; it still remains committed to easing the liquidity deficit towards neutral. As explained by Upasna Bhardwaj and Madhavi Arora, economists with Kotak Mahindra Bank, “The scope for (further) rate cuts (in FY2018) is limited though the liquidity channel will likely remain accommodative".
As a caveat, it is important to note that the above argument implicitly assumes that the RBI would remain focussed on inflation-targeting. There is, of course, another school of thought that cautions against reacting too much to food price-led inflation, on the grounds that such inflation is largely caused by supply-side factors and interest rate increases by RBI wouldn’t help much to reduce such inflation.
How is the Taylor rule-implied interest rate calculated?
The Taylor rule, developed by Stanford University monetary economist John B. Taylor, yields estimates of the appropriate nominal policy interest rate that the central bank should maintain, given prevailing inflation and GDP growth. More precisely, the rule recommends a higher nominal interest rate if inflation exceeds target and if GDP is above potential.
Estimates of Taylor rule are sensitive to the choice of the “real natural rate of interest", i.e. the inflation-adjusted interest rate which is deemed appropriate when GDP growth is stable around potential levels and inflation is near target. A 2013 presentation by Reserve Bank of India executive director Deepak Mohanty deemed the appropriate real natural rate for India to be 1%. However, a subsequent RBI working paper noted that the real natural rate might evolve over time and need not be constant. The authors of the working paper – Harendra Kumar Behera, Sitikantha Pattanaik and Rajesh Kavediya – concluded that the appropriate real natural interest rate in March 2015 was likely between 1.6% and 1.8%.
Thus, in our estimates for Taylor rule-implied interest rate (as presented in chart 1 above), we provide estimates based on both 1% and 1.8% real natural rate. Both the estimates suggest that RBI might consider putting a halt to its current interest rate cut cycle soon. Since January 2015, RBI has cut the policy rate by 150 basis points (bps) so far to 6.5%.
With RBI maintaining upside risks to inflation at a time when Taylor rule-prescribed rates are already above policy rates, the new monetary policy committee will have a job on its hands.