India’s central bank recently announced that the economy’s natural rate of interest has increased post-pandemic and is expected to continue rising. This increase is driven by the growth of potential output, which could potentially limit the scope for monetary policy easing. The natural rate of interest is a critical factor associated with an economy operating at full capacity without generating inflationary pressures. The Reserve Bank of India estimated that the natural rate was between 1.4-1.9% in the fourth quarter of 2023-24, marking a significant increase from the previous estimate of 0.8-1.0% in the third quarter of 2021-22.
The policy rate being set below the natural rate signifies an accommodative stance, while the converse indicates a restrictive stance. Currently, with inflation at 5.1% and the central bank’s key lending rate set at 6.5%, the real rate stands at 1.4%. However, based on the RBI’s estimate of an average inflation rate of 4.5% for this fiscal year, the real rate could potentially increase to 2%. This wide estimate for the fourth quarter has implications for both hawkish and dovish monetary policy committee members.
The RBI also highlighted that rising investment demand would likely propel the natural rate of interest further. It estimated the growth of potential output to be between 5.9% to 8.3%. Despite this positive outlook, the central bank cautioned that disinflation has been grudging and uneven. It emphasized the need to “stay the course” to ensure inflation drops to its target of 4% from the current 5%.
The RBI acknowledged that inflation has been persistent and that the argument of food price shocks being transitory may not hold true based on recent experiences. While inflation does not necessarily have to reach and sustain at 4% for a change in monetary policy stance, even an enduring movement towards the target can be a signal for a pivot in policy. This suggests that the central bank is closely monitoring inflation dynamics and is prepared to make necessary adjustments to achieve its target.
India’s central bank’s assessment of the economy’s natural rate of interest and its impact on monetary policy reveals a cautious yet optimistic outlook. The need to balance economic growth with inflation containment remains a key challenge for policymakers. As India continues its journey towards economic recovery post-pandemic, the role of the central bank in maintaining stability and sustainable growth will be crucial.