India's 'natural' interest rate has fallen to 0.8-1% from 1.6-1.8%, say RBI staff

India's 'natural' rate of interest is estimated to have fallen by nearly a full percentage point in the last seven years, according to Reserve Bank of India (RBI) staff.

In an article released on June 16, the RBI staff said their analysis showed India's potential output growth had slowed down since 2014.

"Correspondingly, the natural rate is estimated to have declined to 1 percent, with a higher confidence band to reflect the impact of post-COVID volatility in key determinants of the natural rate," the article said.

The article is written by Sitikantha Pattanaik, Harendra Kumar Behera, and Saurabh Sharma of the RBI's Department of Economic and Policy Research. The views expressed in the article are not those of the central bank.

Like the real interest rate, the natural rate of interest is an abstract and unobservable concept and must be derived from other data. It is then used to assess the stance of monetary policy.

If the natural rate of interest is lower than the inflation-adjusted policy rate, monetary policy is said to be anti-inflationary or contractionary. If it is higher than the inflation-adjusted policy rate, monetary policy is said to be accommodative.

"When the real policy rate is at or close to the natural rate, monetary policy is neutral, i.e., neither expansionary nor contractionary. This situation is expected to prevail when inflation is aligned to the target and output is at or close to its potential level," the article said.

As per the article, India's natural interest rate was 0.8-1 percent for the last quarter of 2021, 80 basis points lower than 1.6-1.8 percent estimated for the first quarter of 2015.

"Pandemic-induced factors have likely altered natural rate of interest which is sensitive to the choice of methodology and variables used, warranting careful interpretation within the assessment of the monetary policy stance," the article added.

Currently, the real policy rate is deeply negative, with headline retail inflation above 7 percent and the repo rate only recently increased to 4.9 percent. As such, the stance of monetary policy remains accommodative.

Meanwhile, the Monetary Policy Committee (MPC) said in its statement on June 8 that it had decided to "remain focused on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth".

According to the article, both advanced and emerging economies have seen a fall in their natural interest rates in the aftermath of the global financial crisis, as per estimates.

"Natural rates in the Asian economies also declined after the global crisis, reflecting lower trend GDP growth at home and a lower global neutral rate," the article said.