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RBI’s tightening path has a ‘real’ argument in favour of growth

CEA argues RBI’s rate hike won’t hit growth as real interest rates would be low. Many economists agree but give different figures as to what exactly are the real interest rate and neutral rate. An RBI study in 2013 said that real interest rates matter more in investment decisions than nominal rates

June 02, 2022 / 02:09 PM IST

The Reserve Bank of India (RBI) is expected to follow up the out-of-turn policy rate hike in May with a series of hikes during the rest of the year.

The one question markets have is the impact of this tightening on growth. At what point would the central bank’s rate-hiking spree begin to hurt growth?

Enter the real interest rate argument, revisited by the chief economic advisor (CEA) on May 31. After the release of the FY22 gross domestic product (GDP) data, Anantha Nageswaran said that real interest rates would be low despite rate hikes.

“In general, sometimes, interest rates becoming normal need not necessarily be an anti-growth move because you are coming from an extremely low real rate of interest to a low rate of interest. So only when real rates become highly positive, they become restrictive on growth," he said.

The CEA was referring to the economic theory that high real interest rates tend to tamp down on investment by making the cost of capital and funding steep.


An RBI study in 2013 notes that real interest rates matter more in investment decisions even though it appears that nominal rates nudge investors towards decisions.

For instance, loan rate hikes may not prompt firms to stall their investment plans, if rates seem low after adjusted for inflation. “Central banks claim there is a particular threshold or neutral interest rate at which the policy is neither expansionary nor contractionary. When you push policy rates above neutral, you are enforcing tighter policy. In theory, such tightening begins to hurt growth and investments,” said A Prasanna, head of research at ICICI Securities Primary Dealership Ltd.

But what is India’s real interest rate threshold, beyond which growth begins to hurt?

Getting real

A World Bank study in July 2021 states that in the aftermath of external shocks, the neutral real interest rate has fallen to 2.2 percent by 2019 from as high as 6.2 percent in the early 2000s  for emerging market economies such as India.

That is because the growth potential of emerging markets (EMs) has fallen. The International Monetary Fund (IMF) has slashed India’s potential growth to 6 percent in the aftermath of the pandemic. For India, economists believe the neutral real rate is somewhere between 1.5 and 2 percent.

Abheek Barua, chief economist at HDFC Bank, believes that a terminal repo rate of 5.4 percent would be where India’s neutral policy rate may lie.

“If you take the expected inflation for FY23 and after smoothing out base effect and one-time spikes, it would be somewhere around 5.5 percent. Our estimate is that inflation would average 6.2 percent in FY23. So, a repo rate, at 5.4 percent, would leave us with a small positive real rate,” he said.

He expects the central bank to take the repo rate to 5.4 percent by December. Barua adds that this could change if inflation deviates from the expected path. The RBI forecasts retail inflation to reach 5.7 percent by March, while private professional forecasters put inflation in the 6-7 percent band.

Sure, in all probability, the RBI may raise its year-end inflation forecast from the present 5.7 percent to 6 percent or above, given the recent trends in retail inflation.

Analysts at HSBC believe that FY23 inflation would be 6.8 percent, and this would necessitate rate hikes enough to take the repo rate to 5.3 percent in the next six months.

“Thereafter, the RBI is likely to move out of the negative real rate territory by hiking policy rates by 20bps (basis points) in December, taking the repo rate to 5.5 percent. Our FY24 inflation forecast is 5.5 percent, implying that real rates would no longer be negative,” they said in a report dated May 19. One basis point is one-hundredth of a percentage point.

The upshot is that the central bank can hike its policy rate by another 100-110 bps, without hurting growth recovery or investment revival.

Beyond the level of 5.4-5.5 percent of the repo rate, the central bank would prefer to pause and respond only if inflationary drivers are emerging from the demand side.

Shubhada Rao, founder of independent research firm QuantEco Ltd, said that the RBI won’t be in a hurry to move into positive real rates in FY23 itself.

“While the current drivers of inflation are essentially dominated by supply-side shocks, the key risk is that inflation is getting broad-based. The focus, therefore, needs to remain on anchoring inflation expectations. On the issue of real rates, I believe that the RBI will work towards positive real rates slowly and steadily, not in a hurry!” she said.

Here, it pays to avoid aping the US Federal Reserve’s fast pace of rate hikes, economists say. The US economy is battling inflation levels unseen since World War II and the Fed has resolved to hike policy rates fast and furiously to rein in price pressures. For a leveraged economy such as the US, this could spell trouble and economists are already calling for a recession there.

Back here, the dynamics are different as a growing economy such as India should be comfortable with inflation higher than advanced economies. That brings us back to the optimal real interest rate.

The real interest rate is not a static number and is subject to change. “In advanced economies such as the US, there are regular studies to determine the prevailing real neutral interest rate. But it is difficult to pin down the neutral rate for economies such as India due to shortcomings in the measurement of business cycles and output gaps. A simple rule of thumb is to assume that India’s real neutral interest rate will be higher than that of advanced economies,” ICICI Securities’ Prasanna said.

For now, the central bank seems to have enough room for tightening and still be growth-friendly. In fact, holding back on rate hikes may hurt the economy and investment more than higher interest rates.

Franz Kafka can offer a supportive thought to the RBI— “Beyond a certain point there is no return. That point has to be reached.”
Aparna Iyer
first published: Jun 2, 2022 02:09 pm
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