The real interest rate conundrum

A mistake often made when talking about real interest rates is not to distinguish between “price movements” and “absolute prices”. This becomes important when we return to the basic approach to credit policy.

Monetary policy has always been discussed from the perspective of borrowers and therefore it is argued that a lower interest rate promotes borrowing, which can lead to increased investment and therefore growth. This is the nominal interest rate we are talking about.

Now, when inflation goes down, it is claimed that the real cost of borrowing increases if interest rates remain unchanged and therefore there is a need to lower the nominal rate, which is done by lowering the catch rate. retirement.

So, if the repo rate is 5.75 percent and inflation is 3 percent, the real interest rate is 2.75 percent. If inflation drops to 2 percent, the real interest rate rises to 3.75 percent. It is logic.

The household sight

Let’s look at this phenomenon from a household perspective. When interest rates on deposits fall, there is a fall in income which affects purchasing power and hence the demand for various goods and services.

Suppose that when the pension rate is 5.75 percent, the offered deposit rate is 7 percent for a year when inflation is 3 percent. If the RBI were to lower the repo rate to 5.5 percent, if inflation fell to 2.75 percent and the deposit rate to 6.75 percent, the income received in the form of interest would fall. . It is therefore not an optimal situation for the saver.

But here the economist points out that this is not really the case because inflation has also gone down and the real rate in both situations is 4%.

If the household does not recognize this fact, then it is in a state of monetary delusion that needs to be corrected. This is the real interest argument used by economists who advocate rate cuts proportional to the evolution of inflation.

However, it should be noted that inflation is defined as the rate of change in prices and therefore is the first change in the derivative in absolute numbers. So when we say that inflation is going down, it is not that prices have fallen, which would be the case if inflation were negative.

It’s just that the rate of change in prices is lower than it was before, giving the feeling that they have eased. By juxtaposing an absolute number with a number derived prime of a variable which is an index, we created this anomaly.

The angle of the economizer

The same can be presented in a different way. Let’s look at an individual who has say an income of ₹ 5 lakh which was put into a deposit in 2013-14 (see table).

Let this amount be put into a one-year bank deposit, which changes each year based on the banks’ reaction to RBI policy.

Therefore, the income received on this amount would be the payment of interest. Next to it is also juxtaposed the CPI index which is recalibrated according to the evolution of inflation over the years with 2013-14 as the base.

The interest income earned could then be turned into an index that shows how the individual’s income would have evolved.

Now the table shows some really interesting points. First, the individual has actually seen their income erode, which has declined by almost 25% point to point.

Indeed, interest rates have fallen almost continuously on one-year deposits (which were considered the midpoint of deposit rates in the RBI database for the year) by 9 percent in 2013-14. at 6.80 percent. in 2018-19.

Second, when economists say that inflation has also gone down, which is a fact from 9.3% to 3.4% point to point, it becomes misleading as prices continue to rise. , while incomes fall.

The price index has been recalibrated to 2013-14 being the base and inflation calculated on that number, showing that inflation has actually increased by around 25 percent over this period cumulatively.

Third, the last column examines the traditional concept of a real interest rate where the CPI is subtracted from the deposit rate, which indicates a real return of 2.4 to 3.4 percent, which seems a fair rate.

However, no saver would be happy with this situation as there has been a double whammy with falling interest rates and income falling sharply. At the same time, cumulative inflation has eroded purchasing power, and one would be rightly wronged in this situation.

The view of economists that real interest rates have increased will not be accepted when purchasing power is eroded.

This conundrum is not difficult to solve because there is something wrong with the premise when we interpret falling inflation to mean falling prices, which it is not. Prices keep going up at different rates, making it look like we are paying less for the basket of commodities, which is not true.

Therefore, it is probably necessary to set aside the real interest rate argument when arguing for lower interest rates in an environment of falling inflation.

We have to go back to Ayn ​​Rand’s famous words: “Contradictions don’t exist. Whenever you think you are faced with a contradiction, check your premises. You will find that one of them is wrong. It’s in the concept.

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

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