Take the ‘natural’ rate of interest seriously

As the world struggles with a phase of stubborn inflation that can be attacked only with high interest rates that in turn constrict growth, there is some interest in turning to the “natural” rate of interest as a more balanced approach to monetary policy. The “natural” rate of interest is a technically-calculated reference point that neither pushes nor slows the cart of economic growth, allowing it to run on its own internal dynamics. “The ‘natural’ part means that this is the interest rate that is neither stimulatory nor contractionary and is consistent with output at potential and stable inflation,” to quote the IMF World Economic Outlook report of April 2023.

A natural rate is one that does not impact growth either positively or negatively. It is a useful indicator when rate hikes are impacting growth adversely

The discussions come at a time central banks across the globe are concerned with emerging uncertainties as they walk the classic “disinflation glide path” in the light of the persistence of core inflation coupled with “feeble and uneven” growth, as described in the IMF report. The report has cut its forecast of global economic growth (down to 2.8% in April 2023 from 2.9% in January 2023) but enhanced the headline inflation forecast (up to 7.4% in April 2023 from 7% in January 2023). The April 2023 inflation forecast is nearly double the forecast of January 2022.

Disinflation is expected in all major country groups, with about 76% of economies expected to experience lower headline inflation in 2023 but this will come at the cost of growth. The IMF report has observed that there is a 25% probability distribution of world economic growth declining to below 2%, something that has happened only five other times (1973, 1981, 1982, 2009 and 2020) since 1970.  The chance that core inflation, which is inflation other than volatile food and fuel prices, will be higher in 2023 than in 2022 is close to 30%. Thus, the IMF report concludes that the weak growth and persistent inflation will be manifested both in advanced economies and emerging market and developing economies.

This tells us that inflation has fallen the world over only because of the bitter pill of policy rate hikes by almost all central banks. The pill has addressed the symptoms but inflationary pressures remain. Central banks in advanced economies have substantially increased their policy rates to rein in inflation and to anchor inflation expectations. The US Fed has raised rates by 475 bps from H1: 2022 to Q1: 2023; the ECB has increased key rates by 300 bps from H1: 2022 to Q1: 2023; the Bank of England has raised its policy rate by 400 bps during from H1: 2022 to Q1: 2023. Similarly, the emerging market central banks have also increased their policy repo rate during the same period to address inflation.

But globally, central banks aren’t getting any kudos for this. In fact, they have been under attack for failing to foresee inflation and rein it in good time, acting only when the damage was done and there was little option left but to take stiff action. In that sense, the question is: did all the central banks fail, and if so, why, and what must be done now?

These are some of the issues that Raghuram Rajan, the former RBI governor, takes up in an IMF publication called Finance and Development, published in March 2023. Rajan argues that central banks needed public legitimacy to raise rates in an era that was marked by huge public spending to boost the economy amid historic low inflation rates. He says it is not that central banks couldn’t see the coming inflation – they waited for the public to see it to gain the legitimacy to act.

But action isn’t exactly working, so doing less may be doing more. One way out is a policy under which the central bank does not look to either boosting growth or constraining growth. This is where the “natural” rate of interest as a reference point comes in.

A forward guidance on this natural rate will be helpful for the economy in general, and may also serve to smoothen private sector investments

The “natural” rate is best explained using the stark contrasts of 1979 and 2008 by the IMF. In 1979, inflation moved up though the US Fed hiked interest rates to 14% (5% in real terms, accounting for inflation), so the high rates were not high enough whereas in 2008 interest rates fell to zero but this was considered not low enough to boost the economy. Inflation remained low for a decade.

“These two contrasting examples raise an obvious question. How can it be that in the same country a real interest rate of 5 percent is sometimes too low but at other times a real interest rate of zero is too high?” ask the authors of the chapter, ‘The Natural Rate of Interest: Drivers and Implication for Policy”, in the IMF World Economic Outlook report.

The answer is that interest rates can be too high or too low not in the absolute number but with reference to the “real natural rate of interest.”

In the Indian context, too, it can be argued that action by the central bank has failed to rein in inflation. For the immediate, it is critical to return to the Flexible Inflation Target (FIT) of CPI-combined 4% with a band of +/- 2% at the earliest to ensure credibility of the monetary policy in the eyes of the public. The Inflation print for March 2023 released on April 12, 2023 is higher at 5.66% and core inflation (headline inflation excluding food and fuel) is worked out to above 6%. However, the RBI is optimistic in its forecast of the inflation rate at 4.4% for 2024-25 and a growth rate of 6.5%.

What should be the natural rate of interest for Indian economy?

According to the IMF World Economic Outlook April 2023, the natural rate is usually independent of monetary policy and instead driven by real phenomenon such as technological progress, demographics, inequality, or preference shifts for safe and liquid assets. According to the IMF, the natural rate of interest for US during the last 50 years was in the range of 3% and 1%.

The RBI in its April 2022 Bulletin has estimated the natural rate of interest for India. According to the RBI, during Q3: 2021-22, the natural rate of interest was worked out to range of 0.8% and 1% as against 1.6% percent and 1.8% estimated earlier for Q4: 2014-15. Going by these data points, we assume that the natural rate of interest could be in the range of 1% and 2%. Thus, the policy repo rate could be in the range of 5% and 5.5% per cent in 2024-25, assuming inflation rate at 4.4% per cent in a base line scenario.

To conclude, the MPC and RBI should revisit and further probe the natural rate of interest. A forward guidance on this natural rate will be helpful for the economy in general, and may also serve to smoothen private sector investments.

(The writer is a former central banker. Views are personal)