Now that the Reserve Bank has signaled that the rate cycle has turned and given the first rate cut, the academic debate shifts to how low can the repo rate get without compromising the hard won gains on inflation.
Theoretically, instead of looking at an appropriate repo rate, the way to pose this question is to ask what should be an appropriate real interest rate for India. The real interst rate equals the nominal interest rate minus the rate of inflation. It stands to reason that a depositor or a saver will save only if he gets something more than the inflation rate. Currently RBI expects the 2015 inflation rate to be below 6%. Let us assume 5.5%. The policy rate today is 7.75% giving a real return to the saver of (7.75 minus 5.5) 2.25%.
Now the question is what is the appropriate real rate for India. There isn't any scientific answer to it. The RBI governor has mentioned 1.5-2% as an appropriate real rate for India. He is probably taking off from the US situation, where the latest inflation reading is 0.8% and likely moving towards sub 0.5% due to fall in energy prices. And the US ten year bond is straddling 2%.
Dr C.Rangarajan, when he spoke on our channel, said 3% is what the Indians saver expects historically. Below that savers may prefer other instruments like gold or land. However, Rangarajan was clear that he expected the savers real rate to be 3% that is the return of the saver should be 3% above inflation. He is okay with a 2% real return over the sovereign rate or the repo rate. So if inflation is 5.5% for 2015, then the saver should get a return of (5.5+3) 8.5%; while the repo rate can be (5.5+2) 7.5%. However Rangarajan also expects inflation in 2015 to be 4.5-5%. Hence he clearly sees scope to cut repo rates up to 7%.
JP Morgan's Jahangir Aziz looked at India's recent economic history to glean an appropriate real interest rate. He says 2003-2007 was the period when India's inflation was at a tolerable 4.5%, the current account was in balance, and India's potential growth was at its best in recent years. The real rate at that time was 2.6% he says.
But Rangarajan, Aziz and other economists like Eswar Prasad say the real rate should also be related to the potential growth rate of the economy. A JP Morgan report saw potential growth in 2003-2007 at 7.3%. The difference between potential growth and real rate of interest in that period was (7.3-2.6%) 4.7%. Let's apply the same number to the current context. Potential growth has probably slowed to 6.5%. So the real rate today should be (6.5-4.7)1.8%
The Reserve Bank and the Chief economic Advisor see inflation in 2015 at around 5.5%. So adding 1.8% to it, the repo rate should be around 7.3%. This gives space for two more rate cuts. But how soon should these be given. It may make sense to see a few more readings of inflation. Also the RBI should look to see if the fiscal deficit remains reined in. Any relaxing of fiscal deficit can fan aggregate demand and rekindle inflation.
In the medium term, if the government is able to consistently remove supply side constraints and the potential growth itself improves, there will be more scope for rate cuts. But again, a higher potential and actual growth will also require more savings and hence one must never forget the real return to the saver. Needless to add, the control over inflation is also a hard won battle and as economists and central bankers round the world will agree this battle is never won for good. Like liberty, central bankers have to be eternally vigilant on inflation.
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