Negative real interest rate no cause for concern, say economists

The RBI is expected to reduce its policy rate to 4.5% in this rate cycle, economists say

The real interest rate in the economy has turned negative, with the consumer price index (CPI)-based inflation at a more-than-three-year high of 5.54 per cent and the policy repo rate at 5.15 per cent. If this persists, it would be a disincentive for saving, at a time when the interest rate for savings itself is on a decline.

However, this doesn’t indicate a reason to despair as yet. The rise in CPI inflation is primarily on account of food prices, particularly onion, which recently surged to Rs 200 per kilogram, from the usual Rs 20-30 a kg.

With fresh crops set to be harvested in January, prices should reduce and so should the food inflation, from February. Therefore, what should matter is how core inflation — the rise in prices except food and fuel — is working out. In that respect, core inflation has remained soft in India.

Economists say it won’t be right to say interest rates have turned negative just because the headline inflation has risen above the policy repo rate. What matters is the composition of inflation.

“The core inflation, which is at 3.2-3.5 per cent (depending on what measure being considered), indicates real interest rates in India remain among the highest in the region,” said Abhishek Gupta, economist at Bloomberg.

“Unfortunately, the Reserve Bank of India (RBI) is focusing on food inflation and its policy is being guided by onion prices, in the near term. We think the RBI will now wait for inflation to peak before lowering rates,” which could come in April, according to Gupta.

In response to a query on whether getting into a negative real interest rate territory prevented the RBI from further cutting rates in December, Governor Shaktikanta Das said that was not a consideration.

“I won't go into the issue of this real interest rate…. because monetary policy cannot have multiple targets. I had said this in the previous MPC press conference too. The Monetary Policy Committee cannot pursue multiple targets,” Das had said.

“Target is price stability that is inflation, keeping in mind the objective of growth. So naturally, when we adjust the policy rate, we will have to keep in mind how much low it can go, keeping in mind the inflation,” the governor had said.

There are ample reasons for not considering the real interest rate as something serious. “These are all technical terms, which are taken as proxies for other real world things. For example, nominal gross domestic product is a proxy for cash flow of the companies, and real interest rate an indication of cash flow relative to interest cost,” said a senior economist with a bank.

Consumer behaviour doesn’t change with interest rates turning negative, economists say, but a persistent negative real interest rate affects the generation of internal returns for banks, which is happening in Europe.

The RBI is expected to reduce its policy rate to 4.5 per cent in this rate cycle, economists say. Inflation is expected to soften to 4.0-3.8 per cent in H1, according to the RBI’s forecast.