‘Taylor Rule’ Suggests Limited Scope For More Rate Cuts In India

India’s monetary policy committee cut interest rates for the fourth time in 2019 last week — this time by 35 basis points — taking the total quantum of rate cuts to 110 basis points.

The committee maintained an ‘accommodative’ stance, suggesting that further rate cuts are possible. But a comment from RBI Governor Shaktikanta Das, suggesting that a 50 basis point cut may have been “excessive”, left markets wondering whether there is much space for further reduction in rates in India.

Judging the room for rate cuts is never precise. Different models will throw up different results for the ‘terminal interest rate’, which is the level of interest rates consistent with an economy producing output close to its full potential at a targeted level of inflation.

One commonly used equation to determine this ‘terminal interest rate’ is the ‘Taylor Rule’, first proposed by economist John Taylor in 1993.

One of the variations of the Taylor Rule uses an equation based on the following variables:

The real interest rate
The difference between the current level of inflation and the targeted level of inflation
The output gap, which is the difference between the current level of output and the potential output

BloombergQuint used the Taylor Rule to compute the ‘terminal interest rate’ for India at the current juncture. In doing so, we took the targeted level of inflation as 4% — the mid-point of the MPC’s inflation target of 4 (+/- 2) percent. The output gap estimates were based on data provided in the RBI’s monetary policy report in April and the assumption that since then the output gap has widened due to weaker growth. The MPC, in its August resolution, acknowledged that the negative output gap had widened.

According to BloombergQuint’s calculation, the terminal rate works out to approximately 5 percent using the Taylor Rule.

With the repo rate currently at 5.4 percent, the Taylor Rule, hence, suggests scope for another 25-50 basis points before the rate cutting cycle ends.

Given current projections of growth and inflation, the terminal rate for India should be close to 5 percent, which is where we currently think RBI is going, possibly delivering them in two clips of 20 basis points each in the next two meetings.

Rahul Bajoria, Chief India Economist, Barclays.

Bajoria, however, cautioned that one needs to keep in mind the lags involved in policy transmission while judging the room for further monetary policy easing.

Equally, if incoming data suggests a significant change in the inflation or output growth trajectory, the calculation for the terminal rate could change.

Does India Use The Taylor Rule?

To be sure, India doesn’t formally use the Taylor Rule in determining the appropriate level of rates for the economy. However, the 2014 Monetary Policy Framework report, drafted under the chairmanship of former RBI governor Urjit Patel, had suggested a move in that direction.

It may be necessary to start with a simple policy rule in terms of a real policy rate as a context specific benchmark for the MPC, and then gradually move to a Taylor type rule after securing price stability and anchoring inflation expectations.

Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework.

In keeping with this recommendation, former RBI Governor Raghuram Rajan had suggested that the real interest rate, which is the nominal interest rate minus inflation, should be around 1.5-2 percent.

Going by that yardstick, the repo rate can fall to as low as 4.75 percent with current inflation rate of 3.2 percent. However, since the RBI is projecting inflation at close to 3.6 percent in the first half of 2019-20, even the real rate benchmark would throw up a terminal rate of near 5 percent.

Goldman Sachs, in a report dated August 7, said that it sees a high probability of another cut by 25 basis points in Q4 2019. “We do not see space for further rate cuts beyond Q4, primarily because headline inflation picks up and crosses the 4 percent target by the end of the year and output gaps are estimated to close in our forecasts,” the note said.

That said, risks are likely skewed towards further reduction in rates, the report added.