Decoding RBI Policy
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 bps from 150-200 basis point that it maintained until recently. So, does this mean the Reserve Bank has eased the intensity of its fight against inflation?
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
If you 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?
Source: Moneycontrol
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
If you 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?
Source: Moneycontrol
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