Cannot adopt a policy of higher inflation tolerance, says RBI study

While lower real interest rates can stimulate growth and investment, the central bank cannot adopt a policy of higher inflation tolerance as the means to lower real rates, says a recent study undertaken by the Reserve Bank of India (RBI). This is because beyond a threshold the negative impact of inflation on growth outweighs its positive impact through lower real interest rate.

The study titled ‘Real interest rate impact on investment and growth –what the empirical evidence for India suggests’, examined the broad question that higher inflation tolerance is a convenient means to lower real interest rates; but should a central bank pursue such a path?

The study was initiated in the backdrop of the difficult growth-inflation mix encountered in 2012-13, when persistently high inflation required resolute anti-inflationary thrust in the conduct of monetary policy on the one hand, and sluggish growth impulses warranted adequate and unambiguous monetary policy stimulus to spur growth on the other.

The study points out that for the determination of growth and investment at the macroeconomic level, the real interest rate is more relevant, even though the nominal interest rate is important for investment planning at the firm level.

At the macroeconomic level, with rising incremental capital output ratio, the marginal productivity of capital has declined over successive quarters in the last two years, indicating why a lower interest rate alone might not stimulate growth, said the study.

According to the study, at the firm level, both nominal expected cash flows from an investment project and the nominal hurdle rate would invariably presume some underlying inflation expectations, but neither cash flows nor the hurdle rate might be explicitly evaluated in real terms. Besides that, over different phases of the business cycle, the Internal Rate of Return (IRR) and the hurdle rate change, and therefore the nominal interest rate should be compared with the IRR, rather than relative to a level prevailing in the past, to assess whether the interest rate environment is growth supportive.

In a dampened investment climate, the IRR of firms might remain under constant pressure, as corporates face cash flow problems due to sluggish demand conditions, weak pricing power, high input costs, stalled projects at different levels of completion, and delays in collection of receivables after delivery of orders. In a phase of falling IRR, interest rate must decline to ensure that the hurdle rate remains below the falling IRR to be able to revive investment and growth.

The RBI study also said that a central bank can influence real interest rates through financial repression/reforms and lagged monetary policy response to inflation. Real interest rate is a real phenomenon, but it could change in the short-run depending on how monetary policy responds to inflation and inflation expectations.

Empirical estimates using both firm-level and macroeconomic data, and alternative methodologies such as panel regression, value at risk, quantile regression and simple ordinary least squares suggest that for a 100 bps increase in real interest rate, investment rate might decline by 50 bps and Gross Domestic Product  growth might moderate by 20 bps, the study said.