Why RBI should resist the pressures to cut the repo rate

A real repo rate of below 2% when potential GDP growth is well above 5% runs the risk of being too stimulative.

The latest Monetary Policy Committee (MPC) meet of the RBI in early June concluded with a 4-2 vote to keep the repo rate unchanged at 6.5%, where it has been since February 2023.  Both dissents came from academic members of the Committee.  The release of the MPC minutes last week provides the full statement and thereby the rationale for their dissents.

One of the dissenters, Prof. Ashima Goyal of IGIDR has a long track record (media statements, interviews, etc.) of calling for rate cuts, even before joining the MPC.  By contrast, Prof. JR Varma of IIM Ahmedabad has been unpredictably, and hawkishly, dovish. He did call for a tighter stance very early in his term, but since last year has been repeatedly voting for an easier policy stance, and dissenting in favour of rate cuts throughout this year.

Their latest joint dissent has met with approval from some of the financial media. This article will argue that RBI was correct to not lower the repo rate. It outlines conceptual issues pertaining to the appropriate neutral interest rate.

The rationale for inflation targeting stems from Milton Friedman’s natural rate hypothesis developed in the mid to late 1960s.  Friedman argued that since a central bank cannot influence real variables (specifically unemployment or the real interest rate) in the long run, it should ignore them.  The short run boost to growth by cutting interest rates does not sustain. A central bank should target only a nominal variable since that is all that it can control in the long run.

Among the nominal variables that can be targeted, Friedman in 1967 posited that while the price level is the final goal and “most important in its own right”, it would be best to pursue it via an indirect or intermediate target – specifically money growth. However, when a money growth rule was tried in the early 1980s, it turned out to be disastrous. Nominal GNP growth as a substitute for money growth was considered but it has serious operational limitations. (“Targeting Nominal GNP, Spence Hilton and Vivek Moorthy, Federal Reserve Bank of New York Staff Study, 1990)

Hence the Federal Reserve and other central banks started directly targeting inflation, gradually and first implicitly and then later explicitly.  Indeed, the term Inflation Targeting is a huge misnomer that we have to live with.  In my opinion, it would be far more accurate and informative to call it Direct Inflation Targeting.

By 2015, over thirty countries had formally adopted inflation targeting, before the RBI joined the bandwagon in 2016. The noteworthy difference between the 1960s discussions about price stability and the actual policies adopted much later is that the classical goal of price stability, allowing for absolute price level declines, was replaced by a milder 2 percent inflation target in developed countries. India’s chosen target of 4 percent was even milder.

A vital issue that Friedman discussed is why not target the natural rate of unemployment or the natural rate of interest to indirectly reach price stability? His answer was that…”it cannot know what the “natural rate” is (The Role of Monetary Policy, December 1967 Speech)” (The term neutral rate of interest is more commonly used nowadays instead of the term natural).

Based on the natural rate hypothesis, the logic and practice of (direct) inflation targeting implies that the chosen policy rate  ̶  under normal circumstances, and excluding huge cyclical swings  ̶  should not be based on judgements or model based forecasts of the neutral real rate. The above statement may come across to some readers as an arbitrary assertion.  But it is very relevant to India now. The dissenting MPC professors have stated that a real interest rate below 2 percent is appropriate now. On broad empirical grounds this number can be questioned, despite eschewing a specific estimate of the real neutral interest rate.

It is well known that developed countries, for various reasons, have lower potential GDP growth rates than emerging economies. The difference in potential GDP growth now between USA and India is, most likely, at least three percentage points. Across countries and across business cycle phases within a country, the same factors making for high growth tend to push up real rates via higher real (i.e. inflation adjusted) credit demand. Vice versa for low growth. Correspondingly developed countries tend to have lower real interest rates as well.

Accordingly, India’s real interest rate needs to be substantially higher than in USA. The observable nominal interest rate gap will be even bigger since India’s inflation (both target and actual) is higher. A real repo rate of below 2% when potential GDP growth is well above 5% runs the risk of being too stimulative. In short, with inflation still above target, and its worrisome food component far more so, the RBI should not lower the repo rate. Various other issues pertaining to inflation targeting warrant future discussion.