Real interest rate impact on investment and growth: What the empirical evidence for India suggests?

Abstract

Monetary policy is often expected to adopt a pro-growth stance in a phase of prolonged slowdown in growth and sluggish investment activities. Sacrificing inflation, i.e. lowering nominal policy rate even when inflation persists at a high level, is a convenient means to lower real interest rates, which in turn could be seen as a pro-growth stance of monetary policy. This paper, using both firm-level and macroeconomic data, and alternative methodologies such as panel regression, VAR, Quantile regression and simple OLS – finds that for 100 bps increase in real interest rate, investment rate may decline by about 50 bps and GDP growth may moderate by about 20 bps. The empirically estimated sensitivity of investment and growth to changes in real interest rate suggests that if the RBI can lower real lending rates, it can also stimulate growth. Review of literature highlights that a central bank can lower real interest rates either through financial repression or by not responding aggressively to inflation while raising the nominal policy rates in response to inflation. Empirical estimates for India indicate that RBI’s monetary policy response to inflation has not been aggressive, and as a result the Fisher effect –i.e. one for one response of interest rate to inflation that could leave the real rate constant – does not hold. Thus, even when a high nominal interest rate may often signal that monetary policy stance is tight, because of higher inflation and absence of Fisher effect, lower real interest rate may actually be growth supportive. In India, real lending rates in recent years have been generally lower than the levels seen during the high growth phase before the global crisis. But lower real rates in the post-crisis period have coincided with sluggish investment and GDP growth. This is due to the fact that while real rates are lower, marginal productivity of capital, or expected return on new investment has also declined, which has dampened the expected positive impact of lower real rates on investment. In such a scenario, one policy option could be to lower real rates even more, by raising inflation tolerance, i.e. lowering nominal policy interest rate even when high inflation persists or inflation expectations remain high. This paper, however, provides robust empirical justification against any policy of lowering policy interest rates when inflation persists above a threshold level of 6 per cent. The beneficial impact of lower real rates on growth that may be achieved through higher inflation tolerance is more than offset by the harmful effect of high inflation, particularly when it exceeds a threshold level of 6 per cent. This is an inter?departmental study, prepared jointly by a group comprising Shri Sitikantha Pattanaik, Dr. Harendra Behera and Shri Rajesh Kavediya from Monetary Policy Department (MPD), Dr. Abhiman Das and Dr. Arvind Kumar Shrivastava from Department of Statistics and Information Management (DSIM) and Dr. Himanshu Joshi from Department of Economic and Policy Research (DEPR). The study was prepared under the guidance of Shri Deepak Mohanty, Executive Director. The group benefited from extensive and useful comments received from two anonymous referees and from participants during presentations of the study in a seminar of CFOs of corporates and banks, in the DEPR Annual Research Conference, and in a seminar organised in ISI?Kolkata. Views expressed in this paper are entirely personal.