Active Stocks
Fri Dec 08 2023 15:59:53
  1. Tata Steel share price
  2. 129.2 -0.62%
  1. HDFC Bank share price
  2. 1,653.1 1.38%
  1. State Bank Of India share price
  2. 614 0.35%
  1. NTPC share price
  2. 285.25 0.42%
  1. ITC share price
  2. 449.15 -1.95%
Business News/ Opinion / Why has RBI settled for a lower neutral interest rate?
Back Back

Why has RBI settled for a lower neutral interest rate?

Does the RBI now believe that India's potential growth rate is lower than earlier estimated?

Photo: Hemant Mishra/MintPremium
Photo: Hemant Mishra/Mint

The decision by the Reserve Bank of India (RBI) to reduce its policy interest rate by 25 basis points has quite naturally attracted the maximum public attention. However, there is a more technical issue that also deserves to be examined because of its impact on monetary policy thinking in the coming months.

In the short press conference after the policy announcement, officials of the central bank said that the real neutral interest rate in India is now 1.25%. What is a neutral interest rate? Simply put: It is the estimated level of real interest rates at which the economy is growing at potential while inflation is under control. So the economy is chugging along without recession or overheating. The concept of a real neutral interest rate owes its origin to the pioneering work done by the Swedish economist Knut Wicksell on the natural rate of interest, at the beginning of the 20th century.

Now why should this econspeak matter at all? Read on.

The real neutral rate of interest gives us some idea about whether monetary policy at any point of time is too tight or too loose. It is one of the variables used in the famous Taylor Rule to assess whether monetary policy is on the right track.

The empirical problem is that the real neutral rate of interest cannot be directly observed. It has to be estimated statistically. And it changes over time, depending on the inflation target of the central bank, the state of the business cycle and estimates of potential output. For example, several Western economists now believe that the neutral interest rate in many rich countries is well below zero, thanks to the growth stagnation there. Hence the calls for negative interest rates in many countries.

Now back to the RBI. The Indian central bank has broadly been working over the past three years under the assumption that the neutral interest rate here is somewhere between 1.5-2%. Former governor Raghuram Rajan often used this as a thumb rule in his speeches. In a working paper published in 2015, RBI economists had said that the natural real interest rate in India at the beginning of 2015 was somewhere between 1.6-1.8%, with a standard error of 50 basis points.

That number has now been brought down to 1.25% — or around 50 basis points.

Why would that happen? Now the RBI has not changed its inflation target. That leaves us with estimates of potential growth? So here is an uncomfortable question: Does the Indian central bank now believe that India’s potential growth rate is lower than earlier estimated? Or is it adjusting its neutral interest rate to match what is happening in the global economy as a whole? A lot depends on the answers.

Milestone Alert!
Livemint tops charts as the fastest growing news website in the world 🌏 Click here to know more.

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
More Less
Published: 04 Oct 2016, 08:01 PM IST
Next Story footLogo
Recommended For You
Switch to the Mint app for fast and personalized news - Get App