Context: Recently, a study was published in RBI’s July Bulletin which showed that India’s natural rate of interest has seen an upward shift, driven by growth in potential output. The estimate of natural rate of interest for India for Q4 FY24 is at 1.4-1.9 percent as compared to 0.8-1.0 percent for Q3 FY 22.
Natural Rate of Interest
- Natural Rate of Interest is associated with an economy operating at full capacity without generating inflationary pressures.
- It is also referred to as r-star or r*.
Significance of Natural Rate of Interest
- Rate of interest at which savings equals to investment, consistent with stable prices.
- Gauging stance of monetary policy: Difference between real policy interest rate and 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 in neutral when the real policy rate is at the level of the natural rate.
Factors determining natural rate of interest
Natural rate of interest is determined by factors that impact long run saving investment behaviour.
- Long run saving investment behaviour: Factors that reduce saving or increase investment raise the natural rate of interest.
- Longer life expectancy raises savings to support a longer retirement.
- Lower dependency ratio reflects a higher share of working age people in the population and increases savings as those in the workforce typically save more than the elderly and young dependents.
- Higher inequality raises savings as richer households save a larger share of income relative to less affluent families.
- Higher productivity growth associated with new investment opportunities raises demand for capital which increases real interest rates and therefore, the natural rate of interest.
- Risk Aversion: Higher risk aversion induces higher savings in safe assets as a buffer against future economic downturns and lowers investment. Investment in risky assets is found to increase with advancement in digital technologies.
- Fiscal deficits: Persistent fiscal deficits reduce gross saving and crowd out private investment.
- Economic stagnation: An economy can experience rise in saving and fall in investment due to lack of demand for new investment and this could keep interest rates low for longer.
- Monetary policy: Prolonged monetary expansion could fuel debt accumulation and financial imbalances by impacting debt and asset price dynamics, leading to lowering of natural rate of interest over long horizons.
Reasons for India’s rising natural rate of interest
- Demographic factors:
- India’s demographic structure is characterized by large proportion of youth population and a growing working age cohort which tends increase the natural rate of interest.
- Falling dependency ratio which enhances savings and investment potential. However, the COVID-19 pandemic has resulted in decline in life expectancy.
- Other factors propelling rising investment demand:
- Higher Investments for supply chain resilience for diversifying sourcing strategies due to increasing protectionism and geopolitical tensions.
- India’s export thrust through initiatives such as PLI schemes, District as Export Hubs, and promoting export potential of MSMEs could further increase investment demand.
- AI & Digitalisation: Rapid advances in AI & digitalisation will require large public and private sector investments in physical and human capital for acquiring and implementing new technologies and reshaping business processes.
- Enhanced defence spending: The growing geopolitical conflict across the world necessitates significantly stepping up defence spending.
- Investments to address climate change and resilience against extreme weather events: Extensive public and private investments will be needed for both rebuilding and adaptation.