Limits of the real interest rate as a concept

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

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

The RBI has sometimes spoken of an ideal real interest rate, which is in the range of 1 to 2%. There is no formal reason to choose such a range, but it is normally compared with those in different countries. It can be emphasized here that depending on the countries chosen, the references can vary considerably. Two questions can be considered 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 may or may not be an acceptable reasoning for using such points. reference.

The idea of ​​emphasizing the real rate is that nominal interest rates do not matter just as nominal GDP is not discussed. High inflation will statistically overestimate real output, which also tends to push interest rates up. By adjusting nominal interest rates for inflation, we get the real interest rate, which is the true cost of capital.

Therefore, if the RBI sets the repo rate at 6.25 percent (now down to 6 percent) and inflation is 2.5 percent, the real cost to the economy is 3 , 75 percent. Whether it is high or low can be assessed by making an overall comparison. The cost of borrowing or the deposit rate would also be adjusted for inflation. Therefore, if the loan rate is 10 percent, the actual cost would be 7.5 percent.

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

Inflation figures

Additionally, sometimes countries may choose to use core inflation figures rather than headline inflation, as the latter includes food and fuel prices which tend to be quite volatile and skew the price. image of prices. The table is nevertheless revealing of the dispersion of real interest rates between countries.

Relatively more developed countries tend to have low real interest rates while emerging markets have higher rates. Emerging economies are more vulnerable to food and fuel inflation. As inflation tends to increase, the monetary authorities tend to keep a margin for the saver and the borrower, which encourages them to do banking business. A negative yield means that the policy rates are very low and in fact give banks negative returns when dealing with their central banks. India and Indonesia, as the table shows, have the highest real interest rates in terms of policy rates. Assuming that the price indices used are comparable, the larger question is: can these benchmarks be used to guide policy? In other words, can monetary policy be set on the basis of real interest rates in the system rather than nominal?

On second thought, the answer is no. The interest rate is the cost of credit and should reflect the same. In an economy where capital is scarce, where savings lag behind investment, and where countries typically run a current account deficit, it becomes imperative that capital be valued in a different way. Using a benchmark of, say, 1 to 2 percent based on actual rates in developed countries would not be appropriate. It should, At first glance, to be higher.

Moreover, even speaking of deriving the real policy rate which is probably the best rate in the country, the government deficit becomes large and must be taken into account. Emerging countries tend to have higher budget deficits because governments have to support development work. In addition, the pressure to run social protection programs is higher here, making deficit pricing more expensive.

Bond yields

Therefore, the 10-year government bond, which is considered a proxy for government borrowing, also varies considerably from country to country. Countries like India, Indonesia, Russia, the Philippines, Mexico, and Brazil typically have yields above 6% and sometimes over 8%. The US, UK and Germany, on the other hand, have returns below 3%. Intuitively, you have to see that even central bank rates should reflect this difference.

Therefore, if we are talking about real interest rates, the range for emerging markets should be much higher to reflect fiscal responsibility as well as the cost of capital, which is related to the scarcity aspect. Also, pay attention to inflation number one. Headline inflation is often influenced by food and fuel prices, which can be 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 in the range of 5-5.5%. Therefore, one can get a different set of conclusions based on the concept of inflation that is used.

Another variation that can be used is the expected inflation rate (which will have a different sub-concept of expected core inflation) which can give a different number of core inflation. As the concept is still amorphous and leads to different conclusions depending on how the inflation figures are defined, it may be better not to integrate the concept as part of monetary policy.

While the concept of a real pension rate sounds theoretically appealing, its use in policy is fraught with anomalies that can lead to incorrect signaling and is therefore best avoided.

The author is Chief Economist, CARE Ratings. Opinions are personal.

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