Let's get real about rates

Given myriad cross currents across inflation, growth and financial stability, monetary policy in 2024 will have to cross the river by feeling the stones

As the United States Federal Reserve (Fed) and European Central Bank (ECB) get closer to start cutting rates, pressure will rise on the central banks in emerging markets to follow suit. This is not because growth is stalling. Au contraire, growth has consistently surprised to the upside across much of the global economy last year. Encouragingly, this growth resilience has carried over into 2024, with global growth tracking close to trend this quarter.

Instead, the reason commonly proffered for monetary easing is that real rates are prohibitively high. This may apply to some advanced economies that undertook the most aggressive monetary tightening in 40 years. In the United States, for example, core PCE inflation— the Fed’s preferred measure — is below 3 per cent on a year-on-year basis, even though recent monthly momentum has been worryingly sticky. Yet, with policy rates at 5.5 per cent, and therefore forward-looking real rates close to 300 basis points (bps), this allows the Fed potentially some space to ease this year.

 

Everything, everywhere, all at once

But does this logic of high real rates apply everywhere? Take the case of India. Some commentators argue the Reserve Bank of India (RBI) should ease soon, because, with policy rates at 6.5 per cent and headline consumer price inflation (CPI) projected to soften to 4.5-5 per cent later this year, forward-looking real rates of 1.75-2 per cent are prohibitive in India.

There are at least two issues with this argument.

First, projections of 4.5 per cent inflation later this year are still just a forecast. Headline CPI has averaged 6 per cent over the last four years, above the medium-term target of 4 per cent and hugging the upper end of the RBI’s tolerance band. With growth surprising to the upside in recent quarters, the central bank has every justification to wait and see if the inflation softening actually fructifies and whether CPI sustains close to the 4 per cent inflation target, before it begins to ease.

Second, even assuming that inflation progressively softens towards the 4 per cent handle in the coming months, is that reason enough to start easing? To assess that, one must dig deeper into how central banks think about setting policy rates.

The canonical Taylor Rule would argue that the appropriate real policy rate (i.e., policy rate adjusted for inflation) should be a function of the “neutral real rate”, the inflation gap (projected inflation minus target) and the output gap (quantum of slack in the economy or lack thereof), with the relative weight ascribed to each gap a function of the relative primacy attached to inflation vis-à-vis growth.

To be sure, neutral rates are unobservable but should be thought of as the interest rate at which the economy is in equilibrium: Output gaps are closed and inflation is at target. Key to policy settings, therefore, is an assessment of where real neutral rates are in each economy.

There is a general sense that real neutral rates have drifted down globally in recent decades, but especially after the 2008 financial crisis, because of the secular stagnation that characterized advanced economies. Since the pandemic, however, neutral rates in several advanced economies are presumed to have moved up, though uncertainty remains high.
 

Jerome Powell (left), chairman of the US Federal Reserve greets Christine Lagarde, president of the European Central Bank (Photo: Bloomberg/File)

 

What about India?

An important study in 2017 estimated that real neutral rates in India were in the 1.6-1.8 per cent range pre-pandemic. Have neutral rates gone up or down since then? It is not clear.

If investment prospects of an economy rise, increasing the demand for funds, neutral rates should rise. If productivity growth in an economy rises, increasing the return on capital and therefore the propensity to invest, neutral rates should rise.  More broadly, if an economy’s potential rate of growth is seen to increase, neutral rates should rise. 
 

Similarly, if fiscal policy is more expansive, neutral rates should rise. In contrast, if the pandemic resulted in scarring or hysteresis, impinging on potential growth, neutral rates should fall.

Neutral rates: The known unknowns

What does this tell us about neutral rates in India?

Recall, India’s economy was plagued by the “twin balance sheet” syndrome for most of the last decade, with companies’ propensity to borrow and banks’ propensities to lend, falling sharply. This would argue for lower neutral rates pre-pandemic.

But things have changed discernibly since then.

Bank and corporate balance sheets are currently the healthiest in decades. Consequently, credit growth has been running at almost 16 per cent for the last year, almost twice as strong as nominal gross domestic product (GDP) growth of 9 per cent -- a multiple last seen in 2007.

These are not signs that monetary conditions are too tight. If anything, they may be suggesting real neutral rates in India may have risen as balance sheets have been cleaned up and the propensity to lend and borrow has increased.
 

Furthermore, to the extent that increased digitization and infrastructure build-out in the economy push up productivity growth, it should push up neutral rates. Finally, even as the Central government remains committed to fiscal consolidation, the total public sector borrowing requirement currently is still higher today than the years before the pandemic. This would be consistent with higher neutral rates.

In contrast, to the extent that the economy still remains below the pre-pandemic path – and if that suggests permanent scarring from the pandemic – that would suggest lower neutral rates.

In other words, there are too many known unknowns about the neutral rate post-pandemic pulling in opposing directions. This uncertainty shows up in recent estimates of neutral rates in India. One study found that real neutral rates post-pandemic have declined to 0.8-1 per cent. But an alternative model that takes into account both business cycles and financial cycles finds a neutral rate of 2 per cent. 

The jury is therefore still out on the evolution of neutral rates, not just in India, but also globally.

Against this backdrop, for some commentators to simply assert that neutral rates are lower today – as a justification for the RBI to ease even before inflation has settled close to 4 per cent – is to not recognise the different cross-currents at play.

 

Adjusting for the Cycle

Neutral rates apart, policy rates that operate through a Taylor Rule must also take into account the cyclical position of the economy. The fact that growth has surprised to the upside this year but core inflation has continued to soften, and is at multi-year lows, is seen as a puzzle. But this should not be a puzzle.

Despite the upside growth surprise, India still remains below its pre-pandemic path – which suggests slack exists in the economy. This is consistent with the slack in the blue-collar labour market and the fact that manufacturing capacity utilization remains in the early to mid-70s.

In the absence of fresh input price shocks, therefore, this slack can be expected to exert a disinflationary force on core inflation, which is what is playing out. 

What is the implication for policy rates? Slack (i.e., a negative output gap) would argue for actual policy rates to be temporarily below neutral.

In contrast, however, projected inflation at 4.5-5 per cent one year out would still be above the 4 per cent target, which would argue for policy rates to be temporarily above neutral. This is likely what the monetary policy committee (MPC) means when it says it remains “actively disinflationary.” Implicit in this is the important recognition that India’s inflation target is 4 per cent, not a band of 4-6 per cent.

Utilizing the band is understandable in times of large shocks, like the pandemic. But in ordinary times, the target is 4 per cent -- something the central bank has repeatedly tried to emphasize. Those who argue 4 per cent inflation is unachievable, simply have to recall that headline CPI averaged exactly 4 per cent between January 2016 and December 2019, pre-pandemic. During this time, GDP growth averaged 6.7 per cent and real policy rates averaged 2.1 per cent -- hardly considered prohibitive.

In sum, the central bank will have to navigate carefully, because it confronts several moving parts: Uncertainty about neutral rates with the prospect they have increased, negative output gaps, but also forecasted inflation still above target. 

Against this backdrop, those who claim monetary policy must ease pre-emptively, because the potential growth is much higher  and that is resulting in large output gaps, must also recognise that higher potential growth should translate into higher neutral rates. Those who claim that the RBI must focus primarily on negative output gaps must also realise the primacy accorded to inflation in the RBI’s dual mandate during normal times, and the need to focus on achieving the 4 per cent target, especially after the inflation has averaged 6 per cent over the last four years. 

 

Monetary Policy and Financial Stability

Finally, India’s framework is that of “flexible” inflation targeting. Just as the framework creates space to respond to growth shocks from time to time, it must internalize implications for financial stability when the situation so demands.

Healthy bank and NBFC balance sheets have meant that credit growth is running much above nominal GDP growth. While this, by itself, is not a concern for a limited amount of time, it is the quality of the credit that the RBI is correctly very focused on. Unsecured lending has been very strong — with credit card lending growing at more than 30 per cent for the last year — suggestive of excessive exuberance across some parts of the financial system.

Preventing excessive risk-taking has therefore correctly become a key objective for the RBI. To be sure, the principle of “separability” would argue for using rates and liquidity to focus on growth and inflation and the use of macroprudential measures to address any financial stability concerns. The central bank has therefore correctly used the latter as its first line of defence through a slew of macro prudential measures in recent months.

But, though separability is clean in theory, it is messier in practice. Much research has shown that an easing of monetary conditions increases private sector risk-taking behavior. Therefore, if the RBI were to prematurely ease monetary policy, it risks promoting more risk-taking in the financial sector, undermining the macro prudential measures already put in place. To be sure, financial stability is a consideration currently not just in India, but also in Korea, Thailand and Malaysia at the moment. Monetary policy decisions must therefore, when necessary, be influenced by financial stability considerations — what Ben Bernanke dubs as “Situational Leaning Against The Wind”.

India’s policymakers are currently confronting several cross currents. Growth has surprised to the upside even as the economy remains below its pre-pandemic path. Core inflation is at multi-year lows, but credit growth is at multi-year highs. Private investment is yet to broaden out but public investment has been strong. GDP growth is strong but GVA growth has slowed.

In this environment, policymakers will need to be agnostic and nimble. It is challenging, and therefore undesirable, to make strong assessments yet about the post-pandemic equilibrium, obviating the desire to act preemptively. Instead, the RBI has been able to adroitly balance multiple-objectives post-pandemic – inflation, growth, financial stability, foreign inflows – precisely because it has been very nimble and reacted keeping the prevailing macro context in mind.

That approach will need to continue in 2024.  If growth disappoints meaningfully or inflation surprises unpleasantly or financial stability concerns rise, policy will need to respond quickly and commensurately in the appropriate direction. In other words, this will have to be another year when policymakers will need to cross the river by feeling the stones.

Sajjid Z Chinoy is Chief India Economist at J P Morgan. All views are personal