Inflationary pressure may up interest rates

Indian Express, 2 January 2007

Interest rates are likely to move upwards in 2007. This is because currently, after taking account of inflation, interest rates in real terms, are nearly zero. This is below what a stable long run real interest rate in an economy, especially a rapidly growing economy like India, can be. In their attempt to curb inflation and the rising demand for credit, policy makers would need to significantly raise real interest rates above the present levels and make borrowing costlier.

We do a little number crunching to arrive at the above conclusion. While nominal numbers make headlines, the number that actually concerns depositors and borrowers is "the real interest rate" -- the interest rate rate in real terms after taking account of the expected inflation during that year. Much as economists are fond of the concept of a "real interest rate" this is a very difficult entity to measure. First, there is a plethora of interest rates and different people may worry about different rates. Morevoer, short term and long term rates are differnt. Second, there is no measure of expected inflation in India. While we observe past inflation, and that too not very accurately, we cannot say what people expect about future inflation. The measure of past inflation can be based on the wholesale price index (WPI), or the consumer price index (CPI) for different categories of workers - industrial, urban non-manual, agricultural and rural labourers.

To get a measure of the real interest rate we make some simplyfying assumptions. We assume that people are thinking one year ahead. To step away from the problems of differences in borrowing and lending rates, and riskiness of different loans, we use the interest rate on one year government treasury bills. We assume that expected inflation is measured by the most recent past inflation. So if inflation is 6 percent at present it is expexted that it would continue to be 6 percent next year too. Among the different measures of inflation we choose the one based on the consumer price index for industrial workers (CPI-IW). Now we can approximately measure real interest rates as the nominal rate on one year government bonds minus the current inflation rate.

The graph shows how real interest rates have declined since Decemeber 2000. First, the decline was because interest rates were falling and inflation was stable. Later, after Septerber 2004, both were rising, but the real interest rate was falling because inflation was rising faster than the increase in the nominal interest rate. In recent months, after September 2005, it has been falling sharply because of the sharp rise in inflation. Now it is near zero.

While these back of the envelope calculations make many simplifying assumptions, and different interest rate and inflationary expectation measures could give us different numbers, it is unlikely that they would differ much from these in direction. The conclusion that real interest rates are too low and would have to rise would hold using almost any measure. In summary, we would expect policy makers are likely to raise interest rates as they try to curb inflation.

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