One of the oft-repeated criticisms of the Reserve Bank of India/Monitory Policy Committee in recent months has been that real interest rates are too high, and this is hurting economic activity. This is because while inflation is less than 3 percent, the repo rate is 6 percent implying a real policy rate of 3 percent. In the past, the RBI governors indicated that their preference was to keep real interest rates at around 1.5 percent.
The real interest rates faced by borrowers is even higher. Add to this the fact that economic growth appears to be slowing down even as inflation remains well below the 4 percent target and it is trivial for many to conclude that the RBI/MPC is well behind the curve in setting interest rates.
But the above line of thought misses two important points: The first being that there is no absolute ‘fair’ level of real interest rate against which the current level can be judged as being too high or low. This is especially the case in emerging economies like India where data about the state of the economy such as the labour market is either incomplete or unavailable. Further, we are just a few years into our experiment with inflation targeting and there is thus limited understanding of how inflation and economy respond to changes in monetary policy.
The second and more important point that is missed by most is that real interest rates are not an end. They are a tool, a tool to keep inflation around the mandated level. There might be an ex-ante expectation of what level of real interest rate might be necessary to achieve an inflation outcome, but the relationship between inflation and real interest rate is not fixed or cast in stone. What is cast in stone though is the RBI’s inflation mandate – 4 percent average inflation from FY17-21. Given that the inflation mandate cannot change, what must change or evolve is the level of the real interest rate to achieve an inflation outcome.
One way to judge the appropriateness of real interest rates is the realised inflation. If the actual inflation is much lower than the target then, in hindsight, monetary policy was perhaps too tight and vice-versa if actual inflation was much above the target. And it turns out, that the RBI/MPC has delivered on their inflation mandate.
In the first three years of inflation targeting (FY17-19), CPI inflation has averaged 3.9 percent, very close to the 4 percent target. The nominal policy rate (repo rate) averaged 6.3 percent during this period implying a real policy rate of 2.4 percent. This is higher than what the RBI has publicly stated to be the ‘neutral’ real rate which they have said to be around 150bps. But, given that the inflation mandate has been achieved it cannot be said that in hindsight real interest rates were very high in the last three years. So, the best, post facto, determinant of the appropriateness of real interest rates, at least in the next few years, will be whether the RBI/MPC has over- or underachieved its inflation mandate.
But there is a further nuance to it. The RBI/MPC does not base monetary policy on current inflation for that is backward looking. The MPC targets future or expected inflation and the current level of inflation is not necessarily a good predictor of future inflation. Indeed, as I have written before, even household inflationary expectations are adaptive rather than predictive. So, what the MPC is trying to do is to set a real interest rate such that the actual inflation in the future will be close to its mandate of 4 percent.
So, other things being equal, if the MPC expects inflation to be say 5 percent a year down the line, the logical course of action for it would be to increase the interest rate and vice-versa if it expects inflation to be say 3 percent a year down the line. So, the appropriateness or otherwise of monetary policy is to be judged with respect to expected or estimated future inflation and not current inflation. Current data is only useful to the extent it changes the path of future inflation.
Now, to the extent that the realised inflation differs from the RBI/MPC’s expectation, the MPC’s actions would, post facto, appear to be incorrect. And if the actual inflation turns out to be significantly different from its estimate, the MPC’s actions might look downright silly. This is the risk they run, and this is what has happened in the current scenario. Thus, in April 2018, the MPC had estimated CPI inflation to be around 4.5 percent in 4QFY19. The actual inflation in 4QFY19 was 200bps lower at 2.5 percent. It is trivial that if the MPC had perfect foresight, their monetary policy actions would have been different. It is irrelevant what caused the MPC’s estimate to go wrong – it could have been due to global factors or domestic factors or simply a modelling error.
Given that the MPC’s current estimation is for inflation to be around 3.5-3.8 percent by early next year, the current level of interest rates does not necessarily seem very inappropriate. Of course, much will depend on how the state of the economy evolves. One can argue that the MPC can inject systematic error in its inflation forecasts to keep interest rates high/low depending on its bias. This can happen in the short-run but a sustained period of over or underestimating inflation would show up with actual inflation being significantly lower or higher than the target, as discussed earlier.
There is though something for the RBI/MPC to consider. The mandate before the MPC is of flexible inflation targeting. The RBI/MPC is mandated to keep price stability while keeping in mind the objective of growth. The inflation targeting is thus not absolute. And perhaps for this reason, while there is a single point target for inflation, there is a wide band around it (+/- 2%) to determine what constitutes a failure on the part of the MPC to meet its mandate.
The MPC hasn’t really explained how it has interpreted this dual mandate. What level of growth-inflation differential would trigger the MPC to focus on its secondary objective of growth? Say for example the MPC expects inflation to remain at 4 percent for the foreseeable future and GDP growth to be around 6 percent. Now is 6 percent growth low enough for the MPC to take risk of inflation rising above 4 percent (but remain well below 6 percent) for a few quarters? Or is 5 percent GDP growth the threshold in this scenario? After all, it is only inflation sustaining above 6 percent for three consecutive quarters that constitutes a ‘failure’ on the part of the MPC to fulfil its mandate. So, inflation averaging 5 percent for a few quarters is not inconsistent with the MPC’s statutory mandate. This becomes particularly relevant in the current scenario when the MPC expects inflation to remain below 4 percent even by the end of the current year and there are growing signs of economic activity slowing down.
At what point of time (in terms of the level of growth) does the MPC become willing to risk slightly higher inflation to support growth, which is its secondary objective, is a question the MPC should think about. This will help make monetary policy more predictable, which essentially is the objective behind moving to an inflation targeting framework from the purely subjective and discretionary monetary policy framework that we had before.
Ashutosh Datar is a Mumbai-based independent economist.