In India, as is the case in other countries too, the first question that pops up after release of any economic data is: when will central banks cut rates? This can mean two things. The first is that we always want interest rates to come down because it ostensibly fosters growth. Theoretically yes, but factually, it may not always be so.
The other is that the corporate sector always lobbies for lower interest rates with the first reason stated being the justification. Therefore, there is always pressure on central banks to lower rates. Rarely is there a call to increase interest rates. It is only when data released by the RBI shows that financial savings of households have come down that the antennae are raised. Always striving to lower the repo rate hence may not be right.
In this context it would be interesting to see as to what should ideally be the repo rate. Of course, some argue that what matters is not the repo rate but the real repo rate. The real repo rate is simply the repo rate adjusted for CPI inflation. Currently with the repo rate at 6.5 per cent and inflation 5 per cent, the real repo rate is 1.5 per cent. The RBI has also spoken of a theoretical benchmark of 1-1.5 per cent.
The problem here is that the data on inflation rate comes out every month and there can be considerable volatility in these numbers. For instance in the last three months the CPI inflation number was 7.4 per cent, 6.8 per cent and 5 per cent. This gives a real repo rate ranging from -0.9 per cent to 1.5 per cent with a repo rate of 6.5 per cent.
Going by RBI’s forecast of inflation for Q4-FY24 of 5.6 per cent, we will be moving to a real repo rate of 0.9 per cent. At the other end if average inflation for the six-month period is reckoned then the real repo rate would be 1 per cent as inflation till September was 5.5 per cent. Hence the number is open to interpretation.
The problem has surfaced due to the abnormal conditions that set in due to the pandemic. The repo rate was lowered to its lowest ever level of 4 per cent in May 2020.
Repo rate movement
The movement of the repo rate over the years is interesting. The repo rate averaged 7.3 per cent from November 2000 to the onset of the Lehman crisis in September 2008 which was also referred to the period of Great Moderation with robust growth world over.
It averaged then 5.5 per cent between October 2008 and February 2010 when it went down to a low of 4.75 per cent. Subsequently, until March 2016 the repo rate averaged 7.4 per cent after which it averaged 6 per cent until the start of the pandemic. A possible conclusion can be that a repo rate of 6 per cent can be the average expected under normal times.
This in turn means that with the rate at 6.5 per cent, it can go back to 6 per cent at best. The caveat would be that only the immediate period is being considered here. Historically otherwise, a rate of around 7 per cent looks to be in order.
It can however be argued that the repo rate should be juxtaposed with inflation as this is what is being targeted by the central bank. Now, for the period between the introduction of the new CPI index in 2012 and the introduction of inflation targeting in August 2016, the average real repo rate was virtually nil.
This was the time when average inflation was 7.4 per cent which was matched by the repo rate. An interesting observation here is that when inflation targeting was introduced, inflation was not close to even the upper limit of 6 per cent that was fixed for the monetary authority.
Between August 2016 and the start of the pandemic, when the repo rate was lowered to 4 per cent, the real repo rate was 2.2 per cent with inflation being 3.8 per cent and repo rate 6 per cent. This was the positive return provided to the market. But during the pandemic things went awry, as inflation averaged 5.9 per cent till the RBI started raising rates in May 2022; till then, the repo rate remained at 4 per cent.
There was then a negative carry of nearly 200 bps as part of accommodation provided by the RBI or a part of the ideology of doing everything to keep growth ticking.
Since the increase of the repo rate post-pandemic, the real repo rate has been virtually nil.
So what should be the ideal repo rate? Going purely by contemporary history, a rate of 6 per cent looks to be a good anchor. If however, inflation is brought into the frame then the real rate is what has to be fixed either overtly or by induction. But various scenarios have emerged. Before formally getting in inflation targeting the real repo rate was nil, which is also the case today, after RBI started raising the repo rate since May 2022.
But this can mean negative real returns on deposits ultimately. During the pandemic the real repo rate was at (-)200 bps which can be considered as an abnormal period. And from the time inflation targeting started to the pandemic period, the real rate was positive 220 bps.
Under these conditions it becomes difficult for the RBI to use past trends for anchoring the repo rate as different phases have resulted in various scenarios. The market at times goes by the OIS rates (Overnight indexed swap) as a proxy for expectations on the repo rate. These rates are based on trades for periods between one and 12 months and range from 6.85-7 per cent. This can be another indicator for tracking the repo rate.
A conclusion that can be drawn is that a repo rate of around 6 per cent looks fairly well anchored for a country which will typically run an inflation rate of 5 per cent per annum.
While targeting 4 per cent will remain a goal, it is likely to be achieved only occasionally when food inflation enters the negative terrain.
Otherwise with cost push factors at play, this mark looks reasonable which, with a repo rate of 6 per cent, can justify a real repo rate of 1 per cent.
The reviewer is Chief Economist, Bank of Baroda. Views expressed are personal