Relying Only On Natural Rate For Monetary Policy Decision Not Advisable: SBI

A recent report by the State Bank of India (SBI) has cautioned against relying solely on the neutral or natural rate of interest for monetary policy decisions. The report highlights the limitations of using the natural rate as a benchmark, particularly in times of economic uncertainty. It added that unforeseen events and unexpected changes in the economy can render the natural rate ineffective, leading to misguided policy decisions. 

Some economists argue that only unexpected monetary policy shocks or money surprises will affect output and employment while others, particularly those of the Keynesian tradition, assert that anticipated monetary policy shocks also have real effects on the economy.

It stated, "Adherence to a rule-based monetary policy limits the use of unanticipated money shocks to address economic downturns. Unanticipated shocks (if they are large enough) can unanchor inflation expectations that could lead to permanent changes in the long-run inflation trend."

In this context, the report mentioned that the natural rate which has been estimated by the Reserve Bank of India (RBI) recently should not be seen as the benchmark for monetary policy implication. The natural interest rate provides policymakers with a benchmark for the interest rate at which economic activity reaches its full potential and inflation will stabilise. The deviation of policy rates from this neutral rate determines whether monetary policy is accommodative or restrictive, it added.

The natural rate is determined by factors that impact long-run saving-investment behaviour. However, RBI itself agrees that the neutral rate is “not observable” and the estimates are sensitive to “model selection, measurement issues and statistical uncertainty”. That is why it is said that balancing the risk of tightening monetary policy too much against the risk of tightening too little is essential in deciding the policy rate, rather than taking the decision solely based on the natural rate which is imprecise in values.

According to the report, "The crux of this estimate is that if GDP is higher than predicted, the estimate of the natural rate will be higher.. this could mean wait for a rate cut by RBI could get longer…"

Talking about the stance and repo Rate, the SBI stated, "We believe the stance should continue to be withdrawal of accommodation." It added that the central bank is likely to pause as food price movements currently are imparting a positive bias to RBI's 4.5 per cent projection. Also, likely prospects of excess rainfall in August and September could also have a debilitating impact on food prices, the report stated.

“A higher neutral rate at 1.4 to 1.9 per cent... this could mean waiting for a rate cut by RBI could get longer….First, cut likely in December 2024/ February 2025…any disintegrated rate cut and change in stance could front load market movements one way up,” according to the report.