What does the Taylor rule indicate for India?

The rule says targeted real rate = neutral real rate + 0.5*(inflation – target inflation) + 0.5*(growth – trend growth). There are many versions of the rule, so it has to be customized for different countries. Now inflation target is 4% and inflation is almost 3.5%, growth 5%, trend growth, say, 7%, neutral real rate 1.25% as per Reserve Bank of India (RBI), then targeted real rate: 1.25 + 0.5*(3.5-4) + 0.5*(5-7) = 0. That means the nominal rate set by RBI should be 3.5%. At present, Indian reverse repo and repo are 5.15% and 5.4%, respectively. That is 190 basis points away from where we are before the central bank’s policy action.

What is the neutral real rate?

The neutral inflation-adjusted rate RBI should target is the rate at which inflation and growth are as per their target and long-term trend, respectively. Above this the economy has slack, below this it overheats. Some economists say such a rate is compatible with the non-accelerating inflation rate of unemployment. As employment data in India is patchy, this method is impractical (in any case, the inverse link between inflation and unemployment has been getting weaker). Neutral rates have been reducing globally, and RBI once indicated it is comfortable with 1.25%. So, a lower real rate should be targeted in a cyclical downturn.

Is the country’s sustainable growth rate 7%?

Since the 1970s, India’s real growth rate has been edging up if we analyse it by adjusting the cyclical components. The current slowdown is a cyclical one if the last 15-17 years is taken as one cycle, with 2011-13 as the peak. Given demographic, institutional and technological changes, India’s long-term trend growth could hit 8% in the 2020s.

Is “Taylor-ed" inflation target reliable?

Yes, as Karan Bhasin and Harsh Gupta (“Why The RBI Needs A Real Rate Framework", Swarajya, 2 Oct) and Niranjan Rajadhyaksha (“How low can interest rates go in addressing the downturn", Mint, 10 Sep) show plain inflation-targeting may not have the rigour to determine the quantum of cuts or hikes. A 2-6% range means just that, not 2-4% where the midpoint becomes a ceiling. Even a 6-month rolling average of a Taylor estimate for India’s repo rate in the graph above shows RBI is too slow to cut and perhaps raise rates.

What about financial stability?

Any monetary policy that is rule-based (inflation targeting, Taylor rule, etc) can focus on growth and inflation at the cost of financial stability and the early detection of systemically harmful bubbles. Eventually, human discretion is key. The idea of a multi-member monetary policy panel as against one man (RBI governor) deciding rates is to offer many perspectives. Central bank functions go beyond rate-setting. No “rule" by itself is a panacea, it is useful as an input.

Harsh Gupta is the chief investment officer of Ashika Group.

Paras Jain/Mint. Source: RBI
Paras Jain/Mint. Source: RBI