|
What is a neutral real rate?
The concept of a 'neutral' rate of interest is a component of the Austrian theory of business cycle and was first proposed by Knut Wicksell, a Swedish economist. The neutral rate of interest is defined as that rate of interest at which the economy is performing to potential and inflation is at target rate. It is the real interest rate at which savers are sufficiently induced to lend to businesses who will expand using these funds, thus fuelling GDP growth at a level that keeps the economy in equilibrium, without overheating and causing too much inflation.
Since this a theoretical construct this rate cannot be specified accurately. According to Sajjid Chinoy of JP Morgan, "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." (Moneycontrol.com, October 9, 2016)
Importance of neutral rate
Fixing the neutral rate assumes importance in view of the fact that central bank interest rates have to be anchored around the neutral rate. If, for example, the economy is growing slowly, that is, if it is operating below potential, then in order to stimulate the economy, the central banks' policy rates should be below the neutral rate. If the inflation increases beyond desirable levels and if the economy is growing at full pace, the rates would have to be placed above the neutral rate so that the economy cools down, people borrow less and inflation falls.
Inflation targeting
Price levels and inflation targets are crucial in fixing the neutral rate which is a function of the interplay between economic growth, full employment and inflation.
However we do encounter an apparent dichotomy here. We reproduce here a para from our earlier Current Conversations article on inflation targeting: "Hence, today, countries prefer to float their currencies. In this scenario, central banks need a new anchor and have found that inflation targeting gives the best results, especially when operating with flexible exchange rates. Another factor in favour of inflation targeting is that it gives central banks much greater focus. For inflation targeting to be successful, there should be a central bank 'able to conduct monetary policy with some degree of independence', says the IMF. The second requirement is the willingness and ability of the monetary authorities not to target other indicators, such as wages, the level of employment, or the exchange rate." (IMF)
As foregoing shows, inflation targeting works only when central banks pursue it to the practical exclusion of other parameters. Yet fixing the neutral rate requires that the other factors mentioned above be taken into account. Therefore central banks must put targeting inflation front and centre of their policy stance, even as they keep a watchful eye on employment and economic growth.
Calculating the neutral rate
Suppose a deposit in a bank earns 8% interest and inflation is 7%, the real rate of internest works out to just 1%. The real rate of interest is the nominal rate (8%) minus annual inflation (7%). A RBI study in October 2015 assessed the neutral rate to be between 1.6% and 1.8%. However since 2014, the RBI has said that the neutral rate is between 1.5% and 2% - ie, that is the rate of real return where savers will invest in financial assets which in turn fuel growth of businesses and keeps the GDP ticking at a healthy rate, without overheating the economy.
Implications of drop in India's real rate of interest
In its Policy statement on October 4th, the newly minted RBI Governor, Urjit Patel, said that the neutral rate in India had come down to about 1.25%. The Western world has seen real interest rates come crashing down to near zero, on the back of surplus capacity, persisting low demand growth and deflationary conditions. Is a drop in our real neutral rate therefore a signal that we are moving into a new normal of lower growth?
Some who worry about the protracted economic recovery believe there may be a case to lower our growth expectations. Others point out that none of the conditions that are impacting the West are applicable here in India - demand is certainly not on a structural downtrend, overcapacity is being gradually worked out of the system and we are nowhere near deflationary conditions. So why then should there be a case for a lower neutral rate in India?
The answer perhaps lies in acknowledging that the Indian market is a lot more integrated into global markets than ever before. When large parts of the world are at near zero real neutral rates, we will need to contend with lower real rates here in India as more global flows keep coming into India in the quest of higher yields, thus automatically lowering yields even if inflation remains unchanged. Our savers will to that extent bear the burden of abysmally low real returns in the Western world - that's the price we pay for being part of a globally connected market.
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !
Share this article
|
