Neutral rate raised on shift in potential output, says RBI bulletin

Estimate of 1.4-1.9% increase for Q4FY24 sparks debate about possible policy repo rate cut

A Reserve Bank of India (RBI) study has estimated the neutral rate of interest in India between 1.4 per cent and 1.9 per cent for Q4FY24, which is a sharp upward revision from the previous estimate of 0.8-1.0 per cent for Q3FY22, sparking a debate if the central bank can cut the policy repo rate.

The report pointed out that updating the estimates of natural rate of interest for India with post-pandemic data, the study found an upward shift driven by growth of potential output.

“With headline GDP growth rates trending higher after the pandemic, a step-up in the natural rate estimates appears appropriate,” said Aditi Nayar, chief economist, ICRA.

Economists measure the real interest rate in the economy as repo rate minus the one-year ahead inflation. At present, the repo rate is at 6.5 per cent, while average inflation for the fourth quarter is estimated at 4.5 per cent.

The RBI study clarified that the estimate on neutral or natural rate is centred in wide bands of uncertainty, warranting careful interpretation in the assessment of the monetary policy stance.

The report is authored by Harendra Kumar Behera from the Department of Economic and Policy Research (DEPR), RBI. The views expressed in the article are those of the author and do not represent the views of the RBI, it was clarified.

Behera acknowledged that for India, estimating the natural rate becomes particularly challenging in view of significant structural transformations and demographic shifts.

“In particular, pandemic-induced complexities have altered estimates of potential output and profoundly impacted inflation dynamics,” the report said.

“In its Wicksellian origins, the natural rate of interest is associated with an economy operating at full capacity without generating inflationary pressures,” it said.

Observing that the range is wider than the previous estimate, Gaura Sen Gupta, economist with IDFC First Bank, said: “The lower range of the neutral rate indicates space to cut interest rates by 50bps in FY25, while the upper range indicates no space to cut interest rates. Given the wide range of neutral rate, it supports the viewpoint of dovish external MPC (monetary policy committee) members as well as hawkish RBI members.”

“We maintain expectations of a shallow rate cut cycle starting from October/December,” she added.

Two external MPC members — Ashima Goyal and Jayanth Varma — had voted for repo rate reduction of 25 bps and change in stance to neutral in the previous monetary policy committee meeting in June, which was against the majority view of maintaining status quo on both rate and stance. Both Goyal and Varma said the neutral rate should be around 1 per cent.

“The inference is that with the potential output rate increasing significantly in the country, the natural rate of interest or real interest rate would also be rising commensurately,” said Madan Sabnavis, chief economist, Bank of Baroda. “It would also indicate that the current level of 6.5% repo rate and 4.1% inflation rate is within this band and does not call for policy action,” he added.

Commenting that the difference between the real policy interest rate and the natural rate measures the monetary policy stance, the report said when the policy rate is set below the natural rate, the stance is regarded as accommodative, otherwise it signifies a restrictive stance. The policy stance is neutral when the real policy rate is at the level of the natural rate.

In a recent media interaction, RBI governor Shaktikanta Das downplayed the debate around the neutral rate as he said such an estimate is subject to uncertainties and policymaking should not be driven by a theoretical construct.

“Policymaking has to be driven not by an abstract theoretical construct but by actual numbers,” Das had said.


Study points:

Estimate on neutral rate centred in wide bands of uncertainty 

Estimating neutral rate for India challenging due to significant structural transformations and demographic shifts

Neutral interest rate is measured as repo rate minus inflation projection for one year 

Currently, the repo rate is at 6.5% and average inflation for Q4FY24 is estimated at 4.5%