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MOSL: ECOSCOPE-Why high real interest rates could continue in India

ECOSCOPE: Why high real interest rates could continue in India; FY00/03-like slowdown could be preferred over FY10/14-like derailment

 

• India’s CPI inflation stood at a 15-month low of 3.3% YoY in October 2018, while the policy repo rate at 6.5% was the highest in the past two years. Over these last two years, the Reserve Bank of India (RBI) has over-projected inflation 75% of the time with the actual inflation falling as much as 75bps short of its projection in 2QFY19. With headline inflation expected to fall below 3% over the next two prints, the real repo rate will rise above 3.5%. According to the RBI, India’s neutral real interest rate – defined as the difference between 1-year G-sec and 1-year forward inflation projection – at the end of 2016 was 1.25-1.75%. With economic activity weakening since then, the neutral real interest rate could have fallen further. Nevertheless, the real interest rate has almost doubled from ~1.5% in 2016-end to more than 3% currently. Moreover, since the actual inflation has been lower than the RBI’s projections, the actual real interest rate (based on inflation in the T+1 period) has remained consistently above 2.5% for the past six years.
• Why does the RBI not seem concerned about this? Well, forecasting inflation has certainly become a difficult task over the past few quarters, considering the volatility in food prices, which makes it harder for the forward-looking RBI to do justice to its job. Further, the recent sharp weakness in the Indian Rupee (INR) may have also prompted RBI to keep interest rates higher. Whatever the reason, the implications of maintaining high(er) real interest rates are profound. The RBI’s rate policy – intentionally or not –should encourage savings behavior over consumption/investments, which could lead to a slower GDP growth and further disinflation (if not deflation) over the short-to-medium term.