There is a growing belief among financial sector economists that the Reserve Bank of India (RBI) has a specific real interest target in mind that will ultimately determine the size of the rate cuts going forward. RBI Governor Raghuram Rajan has hinted at a ballpark figure of 1.5 to 2 per cent, which he believes is the right real interest rate for the Indian economy. If the real interest rate is calculated with the nominal policy or repo rate as the anchor and if year-end inflation were indeed to settle close to 6 per cent, the scope for further easing seems limited. That said, Rajan has warned against this back-of-the-envelope approach to monetary policy and has emphasised that he finds enough room to cut rates given the current configuration.
The equilibrium real interest has emerged as the Holy Grail of monetary policy not just in India. There is an active debate in the US as to what the real interest rate should be - US Federal Reserve Chairman Janet Yellen has claimed that her own assessment of this interest rate level, given the current state of the US economy, is zero. This is apparently a view that her predecessor, Ben Bernanke, shares and suggests that both have bought into the long-term or secular stagnation hypothesis that predicts that both the US and the rest of the world are likely to see sluggish growth for the foreseeable future.
Why is this choice of real interest rate a big deal? For one thing, the equilibrium real interest rate in the US in the good old days before the 2008 financial crisis was widely accepted to be 2 per cent. That meant that as the business cycle picked up, the Fed would start to raise its nominal policy rate to at least 4 per cent to ensure its core inflation target of 2 per cent. Thus, what Yellen and Bernanke seem to be hinting at is that the American central bank might well start hiking the policy rate this year but the actual hikes will be far less aggressive than along earlier up-moves in the business cycle.
The other bit that is interesting is that the equilibrium interest rate has, unlike the pre-crisis period, ceased to pop out of a neat and handy equation like the Taylor rule that assigns weights to deviations of actual inflation and output (or employment) from their desired and potential levels. Given current estimates of the weights assigned to these two factors, Taylor's rule would produce a nominal policy rate of 3 per cent. The massive fall in the unemployment rate appears to drive Taylor's model to seek fairly aggressive rate action. Thus, Yellen and Bernanke's prognosis seems to make a case for much more 'discretion' in setting the monetary policy rate.
If indeed, discretion is the new mantra for choosing an 'equilibrium' rate, there is a limit to which Rajan can be guided by his research team's models in determining the optimal policy rate. Our prognosis is that Rajan might not just look at either the output or inflation gap to arrive at his number. The 'structural' problem of a falling level and share of household savings in financial assets is clearly something that bothers him. Without an enhanced supply of financial resources, the new architecture of the financial system that the RBI and the government appear to be working towards might just fall apart. Besides, there is an entrenched level of inflation in key food items and services such as health care, housing and transportation that will keep consumer price inflation buoyed, even if the pricing power of manufacturers collapse (as they have with wholesale price inflation fairly deep in negative territory) and fuel prices dip gain. This tough balancing act is likely to keep interest rates above the level that simply looking at the current state of the business cycle would justify. Some rate cuts are certainly due in India and a rate hike in the US seems imminent. But neither central bank is likely to step on the gas.
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is Principal Economist, CII
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