Moneycontrol Pro Panorama | A rate of debate

It is that interest rate where the economy is growing at potential and the inflation rate is at target.

Dear Reader,

If there is one debate that refuses to die among economists, it is that of the real interest rate, or the natural rate of an economy. Natural rate is the interest rate at which an economy operates at full capacity without being inflationary. In other words, it is that interest rate where the economy is growing at potential and the inflation rate is at target.

India’s natural rate was estimated to have been reduced to 1.1 percent, after the global financial crisis. But much has changed since then and a punishing pandemic in 2020 has upended several economic assumptions across the globe. The Reserve Bank of India’s staff has updated the natural rate and estimates it to be in the 1.4-1.9 percent range for the fourth quarter of FY24, far higher than 0.8-1.0 percent estimated for the third quarter of FY22. This is consistent with the view that the economy’s potential growth rate has increased post pandemic, in contrast to popular beliefs of the pandemic dragging the potential down for a long period.

The RBI believes that there are several structural factors contributing to an increase in India’s growth potential. Aside the tax reforms such as the goods and services tax (GST), demographic changes that boast of a large share of working class population, fiscal prudence, and technological innovation leading to productivity gains would contribute to increasing economic potential.

But natural rate is an estimate that tends to change with changing economic conditions, perhaps the reason why traders and investors do not prefer to overthink it.

Why should you and I and other lay people spend time on it?

The difference between the natural rate and the interest rates prevailing in the economy is a measure of monetary policy stance. Whether we are savers or investors, we are thrust smack in the middle of monetary policy in every economic decision.

If the RBI believes that India’s economy can withstand a natural rate higher than previously thought, it means that the central bank won’t be in a hurry to cut policy rates. As such, the communication from central bank officials has been hawkish so far. Note that the crux of the argument given by the two dissenters in the monetary policy committee was based on natural rate. Member Jayanth Varma believes that the current real policy rate of 2 percent is restrictive and should be cut. Ashima Goyal too shared the same view.

But if the RBI’s study shows the economy won’t slow down at 2 percent natural rate, there is no need for it to cut policy rates until it sees inflation back to 4 percent on a durable basis. What’s more, once retail inflation eases towards the target, policy rate cuts may not be more than a cumulative 50-75 basis points since the repo rate is at 6.5 percent.

That said, there are numerous caveats to this esoteric metric. To start with, there are many models to determine the natural rate and the rate is transitory in nature, too. “Balancing the risk of tightening monetary policy too much against the risk of tightening too little is essential in deciding the policy rate, rather than taking the decision solely based on the natural rate which is imprecise in values,” the RBI said in its study.

Needless to say, the natural rate would remain an important input, but just one of the inputs in framing monetary policy. “Policymakers and financial market participants must continuously refine their approaches to estimating the natural rate to ensure that it remains a reliable guide for policies that aim to achieve sustainable economic growth and stability,” the RBI said the study.

Analysts are expecting the RBI to cut policy rates only by the fourth quarter of FY25. Meanwhile, the US Federal Reserve is expected to begin cutting rates in September. An increase in the interest rate differential between the US and India would add to the bullishness surrounding India right now. Fund managers are growing bearish on China which is bringing in large capital flows into Indian markets.

A higher natural rate proposed by the RBI study should prompt us to cut back on hopes of a policy pivot. Would the MPC dissenters relook at their view after this study? That is something to watch for. 

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