Don't bet on the RBI cutting rates

The Reserve Bank of India just published a 200-page report and there’s something you should know....

The RBI may not be in a hurry to cut the interest rates!!! And it’s all thanks to something called the “natural interest rate”.?

But what exactly is this “natural interest rate” and why could it affect the RBI’s decision, you ask?

Okay, to understand that, let’s start from the beginning.?

See, central banks have a lot of things on their plate. They monitor banks, they ensure financial stability, and they print currency to circulate in the economy.

But there’s an additional and crucial bit they’ve got to handle —?inflation. They have to keep prices stable.

And to do that, they often resort to monetary policy changes. Or in simple words, they tweak interest rates to get a desired outcome.?

For instance, let’s say the RBI believes prices of goods and services are rising. They will want to contain it. And to do that, the RBI might increase interest rates. This will make it more expensive for people and businesses to borrow money. Companies may not be too enthusiastic about taking a loan and setting up a factory. People like you and me might decide that buying a car or a home on EMI can wait. Everyone curbs their spending and the demand drops.

Basic economics tells us that demand and prices have a direct relationship. So when demand falls, the prices will eventually fall.

This relationship works in reverse too. If the economy is slowing and the prices of goods and services are falling, the RBI will cut interest rates to nudge people into borrowing and spending money. The hope is that this will drive up prices.?

Simple enough?

Alright then, so let’s go back to focusing on this interesting thing called?“natural interest rate”.

Now imagine you live in a perfect world. It’s a world in which there’s even a perfect level for interest rates. And at that perfect level, there’s no threat of skyrocketing inflation. The economy continues to grow robustly and no one complains about employment either. The economy is in equilibrium and everyone’s happy.

You might argue that such a world doesn’t exist. And you’d be right. It doesn’t.?

But it’s a concept that economists believe in. They think there’s a perfect interest rate that will balance the economy. And they call this the?natural or neutral interest rate. Or even the?R-star.?

?

We won’t get into the intricacies of how it’s calculated since it’s quite complex. We’ll leave that to the economists and just point out that numerous factors can affect the calculation.?

For instance, the demographics of a country.

Look at India’s population. We’re a young country and we’re going to remain so for at least the next couple of decades. A young population, especially one whose disposable incomes are on the rise, has the propensity to invest more and spend more. The need for loans will also rise as this young population builds their lives. And this demand for capital will push interest rates higher.?

But unbridled spending can overheat the economy. So the natural level of interest rates that’s required to keep the economy in equilibrium will also have to be adjusted higher.?

Anyway, the good folks at the RBI just recalculated the R-star for India and?they say that it has shifted upwards — from 0.8-1.0% to?1.4-1.9%.?Our young demography has a role to play in that too.

And this brings us to the question that we asked right at the start — what does this mean for RBI’s monetary policy?

Well, here’s one way to look at it.

Take our policy rate (repo rate). It has been stuck at 6.50% for a while now. On the other hand, inflation is around 5%. That means, the inflation-adjusted or real policy rate is around 1.5%.?

In effect, that puts the real policy rate of 1.5% smack in the middle of R-star’s range.?

And what does that mean?

Typically, if policy rates are below the natural rate, you'd say the policy is dovish. That it is trying to stimulate the economy. And if it is above the natural rate, it's considered hawkish and an effort to slow things down.?

So it seems as though the RBI is neither hawkish or dovish. We’re quite balanced right now. And simply put, that means there doesn’t seem to be much wiggle room for the?RBI to cut interest rates.?

And that’s what we wanted you to know.

Now we’re not saying that this is exactly how it’s going to turn out. After all, the R-star is not the only thing that will influence the RBI. But it’s definitely something worth keeping an eye on and we’ll just have to wait and see how this plays out now.