Neutral rate: There’s no need for a ‘pole star’ to guide RBI’s policy

A hypothetical and error-prone interest rate can’t really claim to ensure a perfect economic balance

The pole star, also referred to as North Star, has been synonymous with surety or precision and has been relied upon by humans since time immemorial. In essence, there is no effect of the Earth’s rotation on the angle of vision between our planet and the pole star, giving the impression that it does not move as the night passes.

In monetary policy, the neutral rate, or ‘R-star,’ has been a guiding light for central banks and is an important concept in economics. It is the hypothetical level of the interest rate that, when all temporary shocks have faded out, can set the economy on a sustainable path of balanced growth and on-target inflation. Interest rates above this rate indicate that the central bank’s monetary policy stance is restrictive, and below it, accommodative or expansionary.

Two references have been made recently to the R-star.

First, the March 2024 Bank for International Settlements paper, Quo vadis, r*? The Natural Rate of Interest after the

Pandemic, avers that “estimates of the natural rate of interest (r*) suggest that it may have increased relative to prepandemic levels.” It goes on to say that “potential shifts in the saving-investment balance and a more inflationary environment, which elicited a strong monetary policy response, may have raised r* and perceptions thereof.”

The implication for central banks and stakeholders could be huge, as it means that the current monetary policy stance isn’t as tight as most market players and analysts think. If the R-star is higher than it was pre-covid, then one should expect inflation and interest rates to remain higher or even rise, instead of falling, even after the one-off effects of the pandemic, hot wars and supplychain disruptions subside. This is contrary to consensus expectations. Even the US Federal Reserve’s median longrun Fed funds rate projection hints at interest rates reverting to pre-pandemic levels.

Jayanth Varma, a member of the Reserve Bank of India’s (RBI) monetary policy committee (MPC), has argued on the basis of the panel’s inflation projection of 4.5% for 2024-25 that with risks evenly balanced, economic conditions do not warrant a repo rate of 6.5%. He opines that a real interest rate of 1-1.5% would be sufficient to glide inflation to its target of 4%, assuming India’s potential growth rate at 8%.

So, how does one interpret these references to R-star? We must remember that it is a theoretical concept and so the choice of methodology, model assumptions and nature of data all play a big role. Moreover, all approaches to its measurement suffer from very high implied standard error, meaning huge uncertainty, with confidence bands up to 6 percentage points. Importantly, this is time-varying; i.e., it can change significantly over time and lie within a wide range, making it relatively difficult to use. Mis-specification concerns also exist. The estimates are ‘structural’; i.e., they assume certain relationships between inflation, the output gap and interest rates for getting to the ‘implied R*’. But if the assumed structural relationship is incorrect, the estimate won’t make sense. A re-assessment of the R* series after making some changes to its structural assumptions is equally problematic. If one has to call time-out in the middle of a game and reset its rules, its credibility would get eroded.

A re-acceleration in labour demand would probably provide the most compelling evidence to the US Fed that the R-star has risen and monetary policy isn’t as tight as being assumed.

An RBI paper in June 2022, Revisiting

India’s Natural Rate of Interest, that dealt with the topic stated that estimates of the natural rate for the postpandemic period suggest a range of 0.8-1.0% for the third quarter of 2021-22, which is lower by about 80 basis points than the earlier comparable estimate of 1.6-1.8% for the fourth quarter of 2014-15. The confidence band around the estimates also increased to +/- 90 basis points, as against +/- 50 basis points for 2014-15. Alternative estimates of the natural rate under a different approach turn out to be higher “in the range of 2.0-2.1% for Q3:2021-22,” meaning that “higher interest rates than warranted may be needed to effectively lean against the wind to restore equilibrium.’’

The recent growth and inflation cycle has been very unusual, driven by many one-offs (pandemic-related scarring and attendant labour market trends, supply chain shocks, etc). Hence, the latest tightening cycle hasn’t had the expected outcome on the underlying economy or business cycle. This has made it difficult to ascertain if R-star shifts come from structural saving and investment factors, structural changes in the post-pandemic economy or from private sector and central bank misperceptions, rendering the R-star level highly uncertain.

One of the reasons that RBI policies under Governor Shaktikanta Das have been effective is that policymaking has been aligned with the real world, guided by observed variables and logical thinking, rather than abstract and esoteric mathematical models. There is no reason why RBI should fall prey to the drumbeat of a neutral rate and base its approach on the so-called pole star of monetary policy in practice.