Explained: What Is Natural Rate Of Interest And How It Impacts RBI's Decisions

Expectations of a rate cut by the Reserve Bank of India might be pushed further down the line if the central bank's latest research is anything to go by. The natural rate of interest for India has seen an upward shift post-pandemic, driven by the growth of potential output, according to its latest bulletin.

The current repo rate, which is the rate at which the central bank lends, set by the monetary policy committee is 6.5%, while RBI's estimates places retail inflation at 4.5% in the second quarter of FY25.

In operational terms, the natural rate of interest serves as a reference for gauging the stance of monetary policy. It is associated with an economy operating at full capacity, without generating inflationary pressures and is defined as the level of the interest rate at which saving equals to investment, consistent with stable prices.

As the natural rate is not observable, it has to be estimated, as it is crucial for setting appropriate monetary policies and assessing them.

The difference between the real policy interest rate and the natural rate measures the monetary policy stance. When the policy rate is set below the natural rate, the stance is regarded as accommodative, and the converse signifies a restrictive stance. The policy stance is neutral when the real policy rate is at the level of the natural rate.

Different models can produce estimates that can differ substantially. Uncertainty also stems from the data, their measurement as well as estimation approaches. Hence, estimates of the natural rate are presented in the form of confidence bands surrounding the results for every model

The natural rate is determined by factors that impact long-run saving-investment behaviour. In particular, factors that reduce saving or increase investment raise the natural rate.

For India, estimating the natural rate becomes particularly challenging given significant structural transformations and demographic shifts, notes a research paper by the RBI released in the latest monthly bulletin.

India’s demographic structure, characterised by a significant youth population and a growing working age cohort, would influence the natural rate of interest positively. This is because such a situation induces higher saving and investment as well as financial liabilities for education, housing, marriage and retirement.

The rising demand for capital is reflected in the recent uptick in investment. This demographic advantage also bolsters productivity and innovation across sectors. As the demographic dividend matures, there may be shifts in saving behaviours as more individuals approach retirement age, potentially moderating the overall saving rate.

All these factors might be contributing to a rise in India’s long-term growth potential.

Some economic models provide a theoretical framework for estimating the natural rate, based on structural parameters like preferences, technology, and policy rules, while others use historical data on interest rates, inflation, and output gaps to estimate the natural rate.

Some models also combine a Phillips curve (describing inflation dynamics) and an IS curve (describing the output gap) to estimate the natural rate by fitting the model to observed data. This is the approach largely used by RBI researcher Harendra Kumar Behera. This approach regards the natural rate as the level of the real interest rate that is consistent with output at its potential level and inflation at target in the absence of transitory shocks to aggregate demand and aggregate supply.

The natural rate of interest for India in the post-pandemic period show an upward movement, driven by a strong growth in potential output, according to the latest estimates by the RBI. The estimate of the natural rate for Q4FY24 is at 1.4% as the lower bound of a wider range of up to 1.9%, compared to estimates of 0.8-1% for Q3FY22.

The current real policy rate at 1.5 – 1.9% is within this band and might explain why the MPC has not shown any urgency to ease policy, according to a research note by Citi, which expects the first repo rate cut only in April 2025.

"Moreover, this neutral rate estimate reaffirms our view of a shallow rate cut cycle (50bps)," Samiran Chakraborty, chief economist at Citi said.

On stance, the bulletin suggests scope for a change before the actual rate cut, he added.

In the State of The Economy article, which is added in every monthly bulletin, the regulator noted that inflation control continues to drive all future decisions of the MPC.

"This does not imply that inflation should reach 4 per cent and stay there before monetary policy considers a change in stance," the article noted. "...instead, based on a careful evaluation of the balance of risks, an enduring movement towards the target should provide signals to forward-looking monetary policy to respond."