The quick succession of repo rate raise has brought the real rate to near equilibrium levels, which has prevented over-heating as well as over-tightening of demand and helped to anchor inflation expectations, according to Monetary Policy Committee (MPC) member Ashima Goyal.

The slowdown and pause was also well-timed, she added.

Equilibrium real interest rate is the short-term real interest rate that, in the long run, is consistent with aggregate production at potential and stable inflation.

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Repo rates

The MPC raised the repo rate (the interest rate at which banks draw funds from the RBI to overcome short-term liquidity mismatches) cumulatively by 250 basis points since May 2022 from 4 per cent to 6.50 per cent. The committee maintained status quo on the repo rate at its last two meetings.

“It is necessary to build on the learning of the past few years where allowing sufficient nominal variation in repo and exchange rates to keep real rates near equilibrium has helped smooth shocks and sustain Indian growth resilience,” Goyal, who is Emeritus Professor, Indira Gandhi Institute of Development Research, Mumbai, said at the MPC meeting held frpm June 6 to 8, 2023.

“The experience has shown that independence from AE (advanced economy) monetary cycles is feasible and foreign inflows are not tightly linked to the interest rate differential with AE rates,” she added.

Better outcomes

She noted that flexibility in inflation targeting, intervention in foreign exchange (FX) markets to reduce excess volatility, economic diversity, supply-side action and good monetary-fiscal co-ordination under supply shocks have all contributed to better outcomes.

“As expected inflation falls, however, it is important that real repo rate does not rise too high. This is what happened in 2015 as international oil prices fell, damaging the economic cycle,” the MPC member said.

Referring to research that suggests that the inflation targeting regime has contributed to reducing inflation expectations, Goyal observed that commitment to such a regime only involves aligning the nominal repo rate with expected inflation.

“Such action, together with the greater impact of official communication in emerging markets, is adequate to bring inflation to target as the effect of shocks dies down. It does not require the nominal repo to be kept higher for longer,” she said.