RBI had emphasised in its last review that its monetary policy stance would be data-dependent, based on the view that the risks to the CPI inflation being close to the milestone of 6% by March 2016 were balanced. Since then, expectations of slow global growth recovery and falling commodity prices have increased the odds of this target being met. Although how growth recovery then evolves in India, and what long-term inflation-target is then set by the government, will determine the stance of monetary policy in the next growth upcycle, it now appears that there might be room for rate-cuts of anywhere between 75-100 basis points over the next year.
We base this statement on a technical reading of real interest rates. The interpretation depends on the underlying economic functions of these rates. These include all the oft-reiterated factors which determine rate setting: the growth–inflation tradeoff, balancing borrowing costs while incentivising savings, preserving the value of the domestic currency, among other things. Intimately related to this is the concept of the real neutral rate, around which real interest rates need to be calibrated to achieve these objectives, based on economic conditions like potential output, non-accelerating rates of inflation, the nominal anchor for the currency, etc.
But which real interest rate might be the appropriate one for the repo rate decision? The easiest one is the real repo rate itself, a straightforward measure that is common knowledge. But this is of limited practical relevance to economic agents, who deal with rates formed by various premia which price credit, tenor, and other risks. The two broad classes of such agents are borrowers (the investment side) and savers (who fund these investments). Setting rates to balance the often conflicting objectives of the two in a manner which optimises non-inflationary growth is the central dilemma of monetary policy in the face of currently low, but with the latent potential for surges, inflation.
At the same time, the choice of inflation metrics is equally important. These reflect the appropriate cost environment. The appropriate real interest rates for a broad class of corporate borrowers is a spectrum of rates deflated by the WPI, (in the absence of a producer price index in India). Borrowers need funds for multiple uses like fixed-block (buildings and machinery) expenditure and funding operating costs (working capital).
The appropriate real interest rates for savers/depositors, on the other hand, is one that is deflated by the CPI, which better reflects the cost-of-living -adjusted returns. Savers may choose between a variety of instruments to deploy their funds, each of which have their own individual risk characteristics.
The accompanying chart shows a spectrum of real interest rates for a class of borrowers and savers. The 364-day T-bill rate is the cost of sovereign borrowing, serving as a benchmark for other borrowers, for funds of a similar maturity. On the loan side, banks’ loan rates are mimicked by an imputed SBI base rate, “backcasted” with appropriate differential to SBI PLR (since the base rate was started just a few years back). Commercial Paper (CP) rates indicate the cost of an increasingly used instrument in the recent months, with corporates accessing funds from markets, often at rates cheaper than banks’ rates. These rates are all taken as 6-month moving averages (6MMA) to even out transient fluctuations.
On the deposit side, the SBI deposit rate might be a good proxy for overall bank fixed deposit rates (Note: we use the SBI rate since this is the only one publicly available as a time-series, over a long period of time, and is reflective of over fixed deposit rates of the banking system). The 364-day T-bill again indicates the spread over the sovereign deposit rate.
What do the numbers show? The borrowing side, first. Borrowing costs are currently highest in the past 9 years. The SBI (6MMA) base rate is currently at 6%, with a print of 8% in December. With inflation expected to rise 50-100 bps by March 2015 from the December levels, a slight drop in real costs is expected by FY15-end, although some of this may be offset by the usual fourth-quarter increase in rates.
From a saver’s perspective, real deposit rates are also at 2007-highs, 6MMA real SBI deposit rate estimated in December at 2.6%, which is above the real rate target. Casual empiricism suggests that such a level is not inconsistent with incentivising savings.
Inflation forecasts (CPI averaging 6% in FY16) and a 75 bps rate cut imply real savings rate at 1.75% and real borrowing rate at 7.25%. Does this justify monetary policy easing, based on the presumption of a “neutral” real rate? The RBI Governor had indicated a comfort with a 1.5-2% real neutral rate, but this is the long-term ideal with inflation at the level targetted, expectations stable and growth at potential. With inflation stabilising (and also with expectations that could likely begin slowing) and in a low-growth environment, an inflation-targeting central bank might be comfortable with a rate moderately lower.
Note however, that a key risk—that of rupee volatility—is not captured in the above analysis. In the event of renewed volatility, investors might be uncomfortable with even the levels of neutral rates we project over the next year, in which case the bets of a rate cut are off.
The author is senior vice-president and chief economist, Axis Bank.
Views are personal