The Hindu Business Line : Exploring the inflation, interest rate, growth nexus

The question whether growth is related to interest rate and inflation has always been one of interest for policymakers. Through an empirically study, A. VASUDEVAN finds out when interest rate goes up, growth could indeed slow down. Also, the lack of evidence of growth-inflation trade-off points to the irrelevance of inflation targeting at this point in time.

THE RBI Governor, Dr Y. V. Reddy...Vicissitudes of Monetary Policy-making. — Paul Noronha

Of late, there appears to be increasing interest in Monetary Policy announcements and its quarterly review if one goes by the number of articles in financial dailies, especially about the `expectations' of market on the eve of pronouncements. These expectations are said to be based on the economic data of the most recent period, the economic developments in countries with which India has close links, the prices of commodities such as crude oil and metals, the geo-political situation and the general outlook of the domestic and international economies.

Market expectations need not converge with policy decisions, but the dominant consensus on an issue does matter. In the first quarter review of the Reserve Bank of India's Monetary Policy on July 25, the announcement of a small hike of 25 basis points in the repo and reverse repo rates coincided with the expectations — a signal for other interest rates to move up.

Inflation targeting

The hike in interest rates has been explained in terms of the need to contain inflation and achieve the desired (if not targeted) growth rate for 2006-07. Some observers have said that this is the first tentative step towards inflation targeting.

Inflation targeting, however, is serious business for it entails enormous preparation in terms of studies on trade-offs between growth and inflation and processes and institutions that have to be put in place for the central bank's exercise to be accountable. Some also contended that the interest rate hike would correct the recent depreciation of the rupee vis-à-vis the dollar.

Sceptics have, however, cautioned that growth could well decelerate on account of the interest rate hike. According to them, the loan rates would rise and slow bank credit. Consumer spending would also decline. As a result, the profitability of firms which depend not merely on price increases but also on the volume of sales would fall and lead to deferment of investment projects.

Some say that the relationship between inflation and interest rates is uncertain. This is tantamount to saying that an increase in interest rates would hardly have an effect on inflation.

What exactly is the relationship among inflation, interest rate and growth? Is the official action that coincided with the market expectations appropriate? Let us view these questions from both analytical and empirical prisms.

Real interest rates

Analytically speaking, it is necessary to recognise that the current high economic growth with relatively low inflation is fostered to no small extent by faster growth in productivity, which would normally mean high (and equilibrium) real interest rate in the long run. Such growth would lead to higher profits, prompting firms to bid for larger financing, pushing up real rates in the process. High real rates of interest brought about by productivity would get a further boost if fiscal deficits are high and business confidence and consumer demand go up.

But once productivity growth stabilises at the present high rate, monetary authorities would necessarily have to focus their attention on keeping inflation low. In other words, inflation risks will have to be thwarted. Such risks could emanate both from within and outside the economy. This explains the rationale of the monetary authorities' action.

Empirical testing of the relationship requires the use of statistical tools — regression, in the least. For this, quarterly data from the second quarter of 2000 to the first quarter of 2006 was used. It resulted in 24 observations. The selection of this period was dictated by the consideration that the liberal economic regime had stabilised by 2000 and data are consistent. Moreover, quarterly data help track intra-year fluctuations better than annual data. The readers are not being saddled with technical details such as the values of coefficients and t-values, as the objective is to draw from the tests insights that could be of policy relevance.

Statistically insignificant

The general notion is that short-term nominal rates of interest move in the same direction as the inflation rate. For the study, the short-term rate is represented by inter-bank call money rate. And in the absence of a better measure, inflation is reflected in the movement of the `all commodities' index of wholesale prices.

The results of our exercise showed that this relationship is positive but not statistically significant. However, in a very low inflation environment, acceleration in inflation could lead to an upward movement in the rate of interest. Anticipated inflation risks should then imply that interest rates would rise.

The question whether growth is related to interest rate and inflation has always been one of interest for policy practitioners. Our results show that growth and interest rates are negatively related but statistically significant, growth and inflation are positively related but statistically insignificant. In other words, when interest rate goes up, growth could slow down. The lack of evidence of growth-inflation trade-off, on the other hand, would point out the irrelevance of inflation targeting at this point in time.

The official action of July 25 seems to suggest that the effects of interest rate on the real sector would be countered if bank credit expands sufficiently. In this context, we conducted two tests. In the first, where growth rate was taken as a function of growth in non-food commercial bank credit and inflation rate, the relationship between credit and inflation and growth was found to be insignificant.

Credit growth is not a major factor in explaining growth. This could be because the relatively sharp credit growth has been in evidence only in the last 2-3 years, and that too largely because of the RBI's prodding.

If this is a good surmise, one wonders whether growth could be better explained by interest rates. Our results showed that while interest rate continued to be negatively and significantly related with growth, growth in credit and inflation are not significant influences on growth.

Growth trigger

This is an interesting result. For, it is possible that a change in the interest rates in the banking sector leads to similar directional changes in the interest rates in the non-banking sectors as well. The all-round changes in interest rates would not only affect the profitability of firms but also the competitiveness of the economy.

Yet another implication is that bank financing is not a growth-trigger. Possibly, market financing should be reckoned along with bank financing to have impact on growth.

However, the question of the level at which interest rates would not affect growth still remains undetermined. And this has now assumed a complex hue in view of the many uncertainties on the international and domestic fiscal fronts. A challenging area, indeed, for policymakers.

(The author, a former Executive Director of the Reserve Bank of India, can be contacted at asurivasudevan@hotmail.com)

More Stories on : Economy | Interest Rates

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Welcome reprieve

Same price, better quality

Global Economic Imbalances — Can US continue to feign ignorance?

Exploring the inflation, interest rate, growth nexus

Guarding the turf from predatory professionals

When shareholders' agreement is enforceable

Database on economy

Agri reforms