An error that is often made when we talk of real interest rates is the failure to distinguish between ‘change in prices’ and ‘absolute prices’. This becomes important when we go back to the basic approach to credit policy.

Monetary policy has always been spoken of from the point of view of the borrowers and hence it is argued that lower interest rate helps borrowing, which can lead to higher investment and hence growth. This is the nominal interest rate one is talking of.

Now when inflation comes down it is argued that the real cost of borrowing goes up if interest rates remain unchanged and hence there is need to lower the nominal rate, which is done by lowering the repo rate.

Hence if the repo rate is 5.75 per cent and inflation is 3 per cent, the real interest rate is 2.75 per cent. If inflation comes down to 2 per cent then the real interest rate increases to 3.75 per cent. This is the logic.

The household view

Let us look at this phenomenon from the point of view of a household. When interest rates on deposits come down there is decline in income which affects purchasing power and, hence, demand for various goods and services.

Let us assume that when the repo rate is 5.75 per cent, the deposit rate offered is 7 per cent for one year when inflation is 3 per cent. If the RBI were to lower the repo rate to 5.5 per cent if inflation drops to 2.75 per cent and the deposit rate comes down to 6.75 per cent, the income received as interest comes down. Therefore this is not an optimal situation for the saver.

But here the economist points out that this is not really the case because inflation too has come down and the real rate in both the situations is 4 per cent.

If the household does not recognise this fact then it is in a state of money illusion that needs to be set right. This is the argument of real interest used by the economists who advocate rate cuts commensurate with inflation changes.

However, it should be noted that inflation is defined as the rate of change in prices and is hence the first derivative change in absolute numbers. Therefore when we say that inflation is coming down, it is not that prices have fallen which would be the case if inflation is negative.

It is just that the rate of change of prices is lower than what it was earlier, which gives a feeling that they have eased. By juxtaposing an absolute number with a first derivative number of a variable which is an index, we have created this anomaly.

Saver’s angle

The same can be presented in a different way. Let us look at an individual who has say an income of ₹5 lakh that was put in a deposit in 2013-14 (see Table).

Let this amount be put in a bank deposit of one year, which changes every year based on how banks react to RBI policy.

Therefore, the income received on this amount would be the interest payment. Alongside is juxtaposed also the CPI index which is recalibrated based on how inflation moved over the years with 2013-14 as the base.

The interest income earned could then be transformed into an index which shows how income for the individual would have moved.

Now the table shows some really interesting points. First, the individual has actually seen erosion in her income which has come down by almost 25 per cent on a point-to-point basis.

This is because interest rates have come down almost continuously on one-year deposit (which have been taken to be the mid-point of the deposit rates in the RBI database for the year) from 9 per cent in 2013-14 to 6.80 per cent in 2018-19.

Second, when economists say that inflation too has come down, which is a fact, from 9.3 per cent to 3.4 per cent on a point-to-point basis, it gets misleading because prices are still rising, while income is falling.

The price index has been recalibrated at 2013-14 being the base and inflation reckoned over this number which shows that inflation has actually gone up by around 25 per cent during this period cumulatively.

Third, the last column looks at the traditional real interest rate concept where the CPI is deducted from the deposit rate, which indicates a real return of 2.4-3.4 per cent, which appears a fair rate.

However, no saver would be happy with this situation because there has been a double-whammy with interest rates coming down income has come down sharply. At the same time, cumulative inflation has eroded purchasing power, and one would be rightly aggrieved in this situation.

The economists’ view that real interest rates have gone up will not be accepted when purchasing power is eroded.

This conundrum is not hard to solve as there is something amiss in the premise when we interpret declining inflation to mean declining prices, which is not the case. Prices do continue to increase at different pace which gives the feeling that we are paying less for the commodity basket — which is not true.

Therefore, it is necessary to probably keep aside the argument of real interest rates when arguing for lower interest rates in an environment of declining inflation.

We need to go back to the famous words of Ayn Rand: “Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong.” It is in the concept.

The writer is Chief Economist, CARE Ratings. Views are personal