The anti-inflationary monetary policy stance of RBI, as reflected in the high nominal policy interest rate since mid-2011, has been generally perceived as one of the factors contributing to the sustained sluggishness in GDP growth and investment activity over past several successive quarters. For a period of more than eighteen successive months since July 26, 2011, RBI?s repo rate was maintained at or above 8%. While growth sacrifice as a means to contain inflationary pressures is context specific, depending on the drivers of inflation, it remains a debatable issue as to whether nominal or real interest rate matters for influencing growth and investment. Theoretical and empirical literature suggests that investment and growth could be sensitive to changes in both nominal and real interest rates.
While economic decisions relating to investment, consumption and saving may be generally based on assessment of nominal interest rates and inflation, effectively, it is the real interest rate which matters. Consultations with representatives of industry and commercial banks revealed that nominal interest rate is more relevant for firm level investment decisions, but inflation expectations and the inflation environment also matter, pointing thereby to the implicit role of real interest rate in influencing investment. A central bank?s assessment of effectiveness of monetary policy generally takes into consideration the transmission of nominal policy rate changes through nominal market interest rates to ultimate goal variables, namely growth and inflation. However, given the argument that it is the real interest rate which matters for real variables like investment and growth, there is a view that nominal interest rate may not always reflect the correct stance of monetary policy. For example, if nominal policy rate is high, but both inflation and inflation expectations are also high, then despite a higher nominal policy rate, the implied real rate may suggest an expansionary, rather than an anti-inflationary stance of monetary policy.
If the level of the real interest rate is a better reflection of monetary policy stance, then how can a central bank influence the real interest rate? The review of literature presented in this paper suggests that a central bank can influence real rates through financial repression/reforms and lagged monetary policy response to inflation. Thus, real interest rate is a real phenomenon, but it could change in the short-run depending on how monetary policy responds to inflation and inflation expectations. In India, lack of one-for-one policy interest rate response to inflation ?an evidence of lack of Fisher effect? explains partly the non-constant real rates over time. As highlighted in the paper, real lending rates in India in recent years have generally been lower than the rates that prevailed during the high growth phase before the global crisis. Thus, despite anti-inflationary monetary policy stance of nominal policy rate, lower real lending rates seemed to suggest the contrary. The key question that this paper then addresses is despite a lower real interest rate environment, why investment and growth weakened, instead of showing some acceleration? On this question, the paper is emphatic that when real interest rate declines, that may coincide with a phase of falling marginal productivity of capital at the aggregate level, and falling IRR at the firm level. In India, the incremental capital output ratio (ICOR) has increased in recent quarters, and correspondingly the implicit marginal productivity of investment has also declined. As a result, lower levels of real interest rate would have also contributed to the slowdown in growth. The next question that this paper explores is by how much the deceleration in growth and investment could result from a hypothetical 100 bps increase in the real interest rate? This is an empirical, country specific issue, and this paper employs alternative econometric methodologies to estimate the impact for India.
Both VAR impulse response and regression estimates suggest that for 100 bps increase in real interest rates, the decline in GDP/non-agricultural GDP growth could be about 20 to 23 bps. Panel regressions (for 24 sectors) and OLS regression estimates suggest that for 100 bps increase in real rates, investment rate may decline by about 50 bps. This result holds for both ?investment to GDP ratio? and ?growth in gross fixed capital formation?. Sensitivity of different sectors to changes in real rates do vary. Quantile regression results point to rising sensitivity of investment to nominal interest rate over higher quantiles, with the median impact for 100 bps increase in nominal effective borrowing costs coming to 88 basis points. In panel regression estimates, the impact of nominal rate on investment ranges between 62 bps to 91 bps. The estimated higher sensitivity of investment to nominal interest rate needs to be interpreted with caution, since nominal interest rate relates to nominal investment and real rate relates to real investment in the estimates.
Among the three major components of domestic demand, government final consumption expenditure does not exhibit statistically significant sensitivity to changes in nominal lending rates. Private consumption expenditure also does not exhibit much sensitivity, reflecting weak dependence of consumption demand on credit and leverage. Thus, the monetary policy impact assessed through changes in lending rates suggest that the impact primarily operates through investment demand, as reflected in the growth of gross fixed capital formation (GFCF). Consumption demand, instead of being sensitive directly to interest rate, is sensitive to investment demand. When investment decelerates, that adversely impacts income and employment prospects, which in turn lowers consumption demand, with lags. This explains the longer transmission lags, and sharper deceleration in investment demand before consumption demand starts moderating in response to tight monetary policy. Since higher inflation tolerance is a means to lower real interest rate, this paper compares the favourable impact of lower real lending rate on growth with the adverse impact of inflation exceeding a threshold level of 6 percent on growth. Estimates suggest that the negative impact on non-agricultural GDP growth from higher inflation tolerance exceeds the positive impact of inflation induced lower real interest rate on growth. Thus, tolerating higher inflation with growth-supportive monetary policy response is unlikely to stimulate growth to the desired extent, since the adverse impact of higher inflation on growth would more than offset the favourable impact of growth-supportive monetary policy on growth. Adverse growth impact of high inflation is seen to operate primarily through compression of consumption demand, since investment demand, as per the estimates of this paper, is more sensitive to lower real rates than higher inflation. The major policy relevant finding of this paper is that lower real rates can stimulate growth, but lower real rates attained through higher inflation tolerance will lead to lower growth with higher inflation, and this unpleasant mix can be best avoided with an overall anti-inflationary thrust in monetary policy, which may accommodate needs of growth only when inflation remains contained below the threshold level of 6 %.
Overall, while this paper finds empirical evidence that lower real interest rates can stimulate growth and investment, it does not recommend a policy of higher inflation tolerance as the means to lower real rates.
Excerpted from the RBI study ?Real Interest Rate impact on Investment and Growth ?What the Empirical Evidence for India Suggests? by Sitikantha Pattanaik, Harendra Behera and Rajesh Kavediya from Monetary Policy Department, Abhiman Das and Arvind Kumar Shrivastava from Department of Statistics and Information Management and Himanshu Joshi from Department of Economic and Policy Research. The study was prepared under the guidance of Deepak Mohanty, Executive Director of RBI
