Experts decode RBI’s ‘neutral real’ rate talk


In the October 4 monetary policy, the Reserve Bank of India in a press conference said it believes the neutral real rate for India has dipped to 125 basis points (1.25 percent) from 150-200 bps that it maintained until recently.

Does this mean the Reserve Bank has eased the intensity of its fight against inflation? For that, a deep dive is need into what are the real and neutral real rates.

Real rate

Ifyou deposit Rs 100 in a bank for a one-year term deposit and get 7 percent on it, the 7 percent figure is the nominal interest rate. Because in one year, prices may have risen 6 percent [because of inflation. The real rate of return is the nominal rate minus one-year inflation. That is 1 percent.

Neutral real rate

It is that interest rate at which the economy is operating at potential and inflation is at the target set by the Reserve Bank.

In 2014, ICICI Securities studied some data that showed that the neutral rate for India is 1.6-1.8 percent.

The Reserve Bank of India (RBI) study of October 2015 also estimated that the neutral rate for India is between 1.6 and 1.8 percent but said that depending on the method of calculation it could wary between 0.6 and 3.1 percent.

From January 2014 to August 2016, RBI officials maintained in their communication that the neutral real rate for India is 1.5 percent to 2 percent.

Why is the neutral real rate important?

Theoretically, if the economy is operating below potential, the policy rate should be below neutral rate. The low rates will help people borrow, consume and push up growth.

On the other hand, if the economy is overheated and is operating to potential, and inflation is therefore higher than target, then RBI should keep the real policy rate above the neutral rate so that people borrow less, consume less and inflation falls.

However, in the just concluded monetary policy, RBI did not argue that the economy is growing below potential and hence policy real rate has to be brought below neutral rate. It said that neutral rate itself has fallen to 1.25 percent from 1.5-2 percent.

What changed in October 2016?

From the trends in 2014 to 2016, RBI merely said neutral rate has fallen globally. But the global neutral rate has been falling since the financial crisis of 2008 due to overcapacity, demographic, ageing, excess saving etc. This process is now troughing-out.

If the RBI arbitrarily said that the neutral rate has fallen to 1.25 percent, can it lower it further to 1 percent and then to 0.75 percent to justify lower and lower policy rates?

Separately, RBI has also dropped its goal to reach 4 percent inflation by 2018 citing amendments to RBI law. Hence the question – has the RBI lessened its attack on inflation?

To discuss and explain what is the neutral rate for India and whether RBI’s argument is justified that the neutral rate has fallen, or that it has given up on or eased up its the fight against inflation, CNBC-TV18’s Latha Venkatesh spoke to economists Sonal Varma of Nomura, Sajjid Chinoy of JP Morgan and A Prasanna of ICICI Securities Primary Dealership.

Below is the verbatim transcript of their discussion.

Q: In November 2014, you had written a piece saying that the neutral real rate for India is probably between 1.6 and 1.8 percent. What is your sense, has the neutral rate for India fallen?

Prassana: That is right, we wrote about it in November 2014. A couple of things which I would like to point out based on that is, one is that on neutral rate I don’t think there can be one precise number. It has to be a range. In fact if you look at both research and how central banks in other countries talk about it, they usually talk about a broad range and in fact when they describe policy also they don’t say it is exactly neutral, they say it is broadly neutral. Those words are used very carefully to convey a sense of uncertainty.

The second point is I think unfortunately RBI has been playing a bit fast and loose with these definitions. Even the former governor was doing it in my view. So, in a sense there is a neutral rate and there is a real policy rate. So, neutral rate for most of the times it can be fixed, but the real policy rate can vary around the neutral rate. So, our understanding is that as far as what we are seeing in India now or in the last two years is the neutral rate based on our estimates is around 1.7 percent and the real policy rate is below it and that is because inflation has been falling and of course growth is also below potential output. So, because of these reasons RBI has been trying to keep the real policy rate below the neutral rate.

As far as your question whether anything has happened for it to change so dramatically in India, I doubt it. In fact the fall in neutral rate in the US has been happening over the last 2-3 years and perhaps we are at the end of that phase and maybe now the neutral rate in US might have also bottomed out.

Latha: Do you think the neutral rate in India has fallen, has something changed over the last one year to make that rate come lower?

Varma: If India was completely a closed economy from that perspective this is a country where we are facing the exact opposite of an aging population. You have a working age population that is set to increase. You have huge investment needs of the economy. Obviously, private capital expenditure (capex) is a bit slow right now but the outlook for investments over the medium term continues to be quite positive and there have been reforms by the government, which suggests that productivity growth should also pick up all of which actually bode fairly well for potential growth.

The inflation psyche is an issue. We have seen inflation come down but inflation expectations have in fact gone higher. In this backdrop it doesn’t look like as far as just India is concerned there are any reasons to believe that the neutral rate would have gone down which is why if you look at the RBI’s argument it is not really linked to India. They are using the global neutral rate having fallen as an anchor for lowering Indian real rate. If indeed real interest rates in India were very tight by which I mean that the real interest rates were significantly higher than the neutral rate then you should be seeing significant disinflationary forces in the economy. Expectations should be coming down.

We did see that during 2013-14 and partly in 2015, which suggests that interest rates were tight and real interest rates were above the neutral rate but in the last one and half year we have seen more signs of underlying inflation stabilising around five percent which actually doesn’t suggest that real inflation rates are higher than the neutral rate. Maybe they are already closer to neutral rate but this is important for a reason. If the underlying inflation is stabilising around five percent and we are okay with real interest rate staying around neutral which means policies are neither accommodative nor tight then why should inflation fall any further which suggests that inflation tolerance is around five percent.

Q: Do you believe that the neutral rate has fallen?

Chinoy: There are three different issues here and sometimes some definitional confusion. First, let’s stipulate where the real policy rate today is. There is a lot of confusion about 125 but the RBI’s forecast for inflation in March of next year is 5 percent. In March of the following year, in 2018 its 4.5 percent. So it is fair to say, if you assume a steady decline, a year from now till next October, they expect inflation to be somewhere around 4.75 – the midpoint of that difference. So my policy rate today is 6.25 and I expect inflation, a year from now to be 4.75, effectively real rate today is already 1.5 percent – that one.

Second, I want to separate acutely the neutral real rate versus were today’s real rate is vis-à-vis neutral. The neutral real rate as has been discussed often is a time varying concept. It depends on potential growth, it depends on technology, on preferences, on savings behaviour, on investment behaviour and it is like potential growth, it’s unobservable. So for us to say here is what it was yesterday or today is different, but the larger point is the actual real policy rate is only at the neutral rate when output caps are zero or closed and inflation is at its long-term target.

Now neither of those conditions is fulfilled in India. Our long-term target for inflation is 4. Today inflation is 5 and output gaps maybe closing but is still negative. So if you apply a typical Taylor rule, which most central banks in the world use, what that suggest is very rarely are actual real policy rates at neutral – that is an unique situation, so for us to claim at every policy for market to say the policy rate is at neutral, is just not right; policy rates will only be at neutral when output gaps are closed and inflation goes to its target.

Q: The RBI said we are reducing the neutral rate itself. I am not able to get that argument. Okay, if prices are rising then you increase the gap between neutral and real. If prices are falling and there is an output gap then you reduce the gap between neutral and real but why the RBI did said that the neutral rate itself has fallen – that looks like an insidious argument. Would you agree with that?

Chinoy: Neutral rates also are time varying. The neutral rate, I would argue, in India in 2013 is very different from 2016 and I will give a simple reason, we can talk about potential growth but the fact is let’s take a simple part of it – exports, two years ago were growing at 8-10 percent. Exports today are either contracting or at zero. It’s very hard to make the case in this global economy that India’s potential growth today is the same as it was two years ago. Yes, you have done a bunch of reforms which will take potential five years from now but today I would argue that potential is perhaps lower than the last two years, dragged down by global developments. This is true in every emerging market and therefore I am not surprised that maybe at the margin neutral rates have come down.

Q: Are you convinced that the neutral rate should have fallen. I can even take it if the real rate and the neutral rate difference is reduced. Two years from now – okay exports, but how much is India an exporting country. Within India itself if anything, the Q2 numbers are likely to show that earnings has grown, aggregate demand has grown for two-wheelers and even for a whole range of consumer products. At this juncture is the RBI justified in saying that the neutral rate has fallen?

Prassana: I think the question should be post to RBI whether they are saying that implicitly that the potential growth rate in India is falling. Are they saying that the return on investments in India is falling, are they saying there is going to be excess savings over investments in India and these questions should be asked to RBI?

Unfortunately, they didn’t give much of an opportunity for you as you wanted to post more question but that apart I would agree with Sonal here, as she said the proof of the pudding is in eating. You observe the inflation, the underlying inflation, the core inflation after stripping out petrol and diesel and perhaps even gold. I think it is more or less being sticky over the last several months. A granted it’s been at the lower end of the range which we have observed but it is more or less around 5 percent and doesn’t show any signs of budding down, which tells me that there is not too much slack in the economy and therefore I do not believe that there is any structural reason to say that the neutral rate should fall.

However, when we are comparing neutral rates observed in the West particularly in the US and other developed economies and emerging economies. I think what is observed in those countries, should be the floor. The Federal Reserve in its latest projection said that the long-term Fed fund target rate should be at 2.9 percent and of course their inflation target is 2 percent, which means they are working with long-term neutral rate of around 0.9 percent. So I would argue that 0.9 to 1 percent should be the absolute floor where other countries are concerned and given the kind of growth differentials and the productivity differentials and the expected return differential between India and US, the neutral rate in India should be higher.