The Reserve Bank raised the repo rate 11 times between March 25, 2010 and July 26, 2011. The increase in July was by 50 basis points or 8.00 per cent. The cumulative increase in the repo rate over this period was 325 basis points. It remains to be seen what course of action the RBI takes on September 16.

Along with the repo rate, the reverse repo rate was also increased . In India, the RBI uses repo/bank rate as the ceiling and reverse repo rate as the floor within which the call money rate fluctuates.

But the real call money rate is still negative. For example, inflation in terms of the core wholesale price index (WPI) is 9.76 percent, whereas the prevailing nominal call money rate is 8.04 per cent, implying a real call money rate of minus 1.72 per cent. If we take expected household inflation estimated by the RBI, which is well into double digits , the real rate of interest is negative.

So what is the appropriate real rate of interest for India? Should the RBI increase the call money rate further or not? In this context, Mr. Knut Wicksell, a Swedish economist developed the concept of natural or neutral real rate of interest in the 19{+t}{+h} century. It is defined as the rate of interest consistent with a stable price level.

In its modern form, it is defined as the real short-term interest rate that is consistent with a stable rate of inflation. Hence, it is also called the non-accelerating inflation rate of interest (NAIRI).

Natural rate of interest

The natural rate of interest is an important benchmark for monetary policy. It helps the central bank to understand the impact of monetary policy on economic activity. For example, if the actual real rate is equal to the natural rate of interest, the monetary policy is more or less neutral. An upward deviation of the real rate of interest from the natural rate tends to have contractionary effect on economic activity and will have downward pressure on inflation.

On the other hand, a downward deviation of the real interest rate from the natural rate of interest tends to have stimulating effect on economic activity and upward pressure on inflation. This role is illustrated in Taylor's rule, according to which the real rate of interest exceeds the natural rate of interest when inflation exceeds its target rate and vice versa.

Unfortunately, the natural rate of interest is unobserved. So it has to be estimated or inferred. Economists sometimes use the average of the actual real short-term interest rate over a long period time as a proxy for the natural rate of interest.

This approach is based on the assumption that the central bank in the short run changes the short-term real interest rate in response to changes in inflation.

Over time, the sum of the cyclical component of the real interest rate due to monetary policy will be close to zero. Therefore, the annual average of real interest rate over time will be equal to the natural rate of interest. As per this method, the natural real call money rate was found to be 2.99 per cent during 1986-2011.

But the historical average method may give us misleading measure of the natural rate of interest if the rate of inflation in the period under consideration is not stable. Under such situation, this method may either underestimate or overestimate the natural rate of interest.

Another limitation of this method is that it assumes the natural rate of interest to be constant. If we look at the data on core inflation in terms of the WPI, we find that it did not use to be stable during 1986-2011. As per the behaviour of core inflation, inflation increased during 1986-1995 and 2000-2011, whereas it declined during 1995-2000 (see Table).

So the annual average method may not give us the true measure of the natural rate of interest. And there is no reason to believe that the natural rate of interest is constant. An alternative way to estimate the natural rate of interest is to use a statistical technique.

Kalman filter technique

Before we estimate the neutral rate of interest, let us form a preliminary view of the neutral rate of interest. As core inflation increased during 1986-1995 and 2000-2011, the natural rate of interest might be higher than the actual real rate of interest.

This also implies that the monetary policy was probably expansionary. On the contrary, the core inflation decreased during 1995-2000. This implies that the actual real rate of interest was perhaps higher than the natural rate of interest and, hence, the monetary policy was probably contractionary.

With this preliminary idea about the evolution of the natural rate of interest in our mind, we estimate the time varying natural rate of interest using Kalman filter technique. We use real call money rate and core WPI inflation for the purpose of estimation.

We use core WPI because changes in oil and food prices are highly volatile and can adversely affect the headline WPI inflation. On the contrary, the core inflation shows the broad underlying trend in inflation, which is affected by demand shocks.

The estimate of the natural rate of interest ranges from 2.01 percent during 2000-01 to 2010-11 to 4.08 percent during 1986-87 to 1994-95 (see Table). It is found to be quite close to those obtained in the US and Euro area, which place the natural rate of interest in the range of 2-3 percent. As expected, the estimated natural rate of interest, on average, used to be higher than the actual real rate of interest during 1986-1995 and 2000-2011.

MONETARY POLICY

In other words, the monetary policy was probably stimulative during those time periods. On the contrary, the natural rate of interest, on average, found to be lower than the real interest rate during 1995-2000. Accordingly, monetary policy was probably contractionary. This is quite consistent with the fact that inflation was rising when natural rate of interest was lower than the real interest rate and vice versa (see Figure and Table). This is as per Wicksell's prediction. Therefore, if the RBI wants to end the increase in inflation in near future, the actual real rate should be brought approximately to 2.01 level.

But it has been argued that a further increase in interest rate would affect economic growth and increase capital inflows to India. Theoretically, if the actual output grows faster than the potential output in the short-run, a contractionary monetary policy is required to stabilise aggregate demand.

Otherwise, it would result in only rise in inflation via increase in inflationary expectations because there is no trade-off between inflation and growth (money is neutral) in the long run.

As the economy is expected to grow at 8.6 percent, which is perhaps higher than the trend growth rate, accommodative stance of monetary policy need to be removed. An increase in interest rate may need to be accompanied by some capital controls to discourage capital inflows.

The Kalman filter technique should be used with caution for policy decisions because it is correct or useful primarily from a statistical point of view.

(The authors are Assistant Professor of Economics. IIM-Indore, and Professor of Economics. IITMumbai, respectively.)

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