Limits to real interest rate as a concept: Business line April 5 2019

In a capital-starved economy where savings lag investment, a low real interest rate cannot reflect the true cost of credit

The concept of real interest rate is quite nebulous but it has entered the monetary policy lexicon where such benchmarks are used to justify interest rate actions. As there is no standard definition of which interest rate to use, in the Indian context, the RBI’s reference rate — the repo rate — is used, which is then linked with the inflation rate.

Here too, there can be a different approach when defining inflation. But the logical way of looking at the real interest rate is to see which index is being targeted in the monetary policy, which in our case is the CPI.

The RBI at times has spoken of an ideal real interest rate, to mean one that is in the range of 1-2 per cent. There is no formal reason for choosing such a range, but it is normally benchmarked with those in different countries. Here it may be pointed out that depending on the countries chosen, the benchmarks can vary significantly. There are two issues which can be examined here. The first is the structure of interest rates — both nominal and real — prevailing in comparable countries today, and the second is whether or not there can be any acceptable reasoning for using such benchmarks.

The idea of emphasising on the real rate is that nominal interest rates do not matter just as nominal GDP is not spoken of. High inflation will statistically overstate real production, which also tends to lend an upward bias to interest rates. By adjusting nominal interest rates with inflation the real interest rate is arrived at, which is the true cost of capital.

Hence, if the RBI sets the repo rate at 6.25 per cent (brought down to 6 per cent now) and inflation is 2.5 per cent, the real cost for the economy is 3.75 per cent. Whether this is high or low can be gauged by making a global comparison. The borrowing cost or deposit rate would similarly be adjusted for inflation. Therefore, if the lending rate is 10 per cent, the real cost would be 7.5 per cent.

The table shows the average real interest rates of various countries in March 2019. There can be variants used by central banks, such as average rates for the year or preceding year to form benchmarks, as inflation tends to vary over months.

Inflation numbers

Also, at times, countries may choose to use core inflation numbers rather than headline inflation as the latter includes food and fuel prices which tend to be quite volatile and distort the price picture. The table is nonetheless indicative of the dispersion of real interest rates across countries.

The relatively more developed countries tend to have low real interest rates while the emerging markets have higher rates. Emerging economies are more vulnerable to food and fuel inflation. As inflation tends to increase monetary authorities tend to keep a margin for the saver and borrower which gives incentive to do banking business. A negative return means that policy rates are very low and actually give negative returns to banks when dealing with their central banks. India and Indonesia, as can be seen from the table, have the highest real interest rates from the policy rate perspective. Assuming that the price indices being used are comparable, the wider question is can these benchmarks be used to drive policy? In other words, can monetary policy be drawn on the basis of real interest rates in the system rather than nominal ones?

On deeper thought, the answer is no. Interest rate is the cost of credit and should reflect the same. In a capital scarce economy where savings lag investment and countries typically run a current account deficit it becomes imperative for capital to be priced in a different manner. Using a benchmark of say 1-2 per cent based on real rates in developed countries would not be appropriate. It should, prima facie, be higher.

Further, even when talking of deriving the real policy rate which is probably the best rate in the country, the government’s deficit becomes important and should be factored in. Emerging countries tend to have higher fiscal deficits as governments need to support development work. Also the pressure to run social welfare programmes is higher here, which makes pricing of deficits more expensive.

 Therefore, the 10-year government bond, which is taken as the proxy for government borrowing, also varies significantly across such nations. Countries like India, Indonesia, Russia, the Philippines, Mexico, and Brazil typically have yields of above 6 per cent and, at times, over 8 per cent. The US, the UK and Germany, on the other hand, have yields of less than 3 per cent. Intuitively it should be seen that even the central bank rates should reflect this difference.

Hence, if at all we are referring to real interest rates, the range for emerging markets should be much higher to reflect the fiscal responsibility as well as the cost of capital, which is linked to the scarcity aspect. Also, one has to be careful about which inflation number one uses. The headline inflation is often influenced by food and fuel prices, which can be either high or low. Core inflation makes more sense, and in the Indian case would mean a real repo rate of 75 basis points, with the index being in the range of 5-5.5 per cent. Therefore, one can get a different set of conclusions based on the concept of inflation that is used.

Another variant that can be used is the expected inflation rate (which will have another sub-concept of core-expected inflation) which can yield a different core inflation number. As the concept is still amorphous and leads to different conclusions depending on the way the inflation numbers are defined, it may be better not to bring the concept in the monetary policy framework.

While the concept of real repo rate does sound theoretically alluring, using it in the policy framework is fraught with anomalies that can lead to incorrect signalling and is hence best eschewed.