Those whom keep a close eye on monetary policy will realize that the real interest rate at the moment is positive. My data suggests it is above 1% mark right now given how the Overnight Policy Rate is at 3% and inflation is hovering around 2% with core inflation being slightly lower than headline inflation.
Despite an abstraction and not directly observed like the everyday nominal interest rate, it is the real interest rate that is crucial in determining decision between consumption and saving/investment in most cases. This is not to say the nominal interest rate is not an abstraction. It still is but real interest rate is not immediately understood or observed by laypersons as nominal interest rate.
The reason I am bringing up the issue about real interest rate is that I think there is a worry of a slowdown in the domestic economy, especially with European and Chinese economies showing signs of stress. And I am always not keen of shoring up the economy with fiscal policy in the traditional way as long as monetary policy can do the jobs well. I also think that monetary policy has done an excellent job in the past few years amid serious unprecedented crisis despite Keynesian’s liquidity trap theory, which appears to be irrelevant: as market monetarists have successfully argued, the fixation on interest rate is overrated in zero-interest rate situation. Market monetarists, the successor to the monetarism of the 1970s, of course, argue more about monetary policy but let us leave that aside for now because I know they would not like my fixation with interest rate here.
With more than 1% real interest rate, this creates the incentive to save more than to spend in the economy. Or to invest less. The bottom line is that it has a negative impact on economic growth.
One also has to remember that the OPR is the base rate. There are other rates based on the OPR and they are priced higher. This means the relevant real interest rate are higher than 1% for consumers and businesses.
Furthermore, in the free (or rather, maybe, just efficient?) market, I would assume the optimal real interest rate is 0%. This suggests that even under free market environment, the real interest rate is too high.
There are other considerations in the settings of the rate. One big consideration is the management of inflation. But with demand-pull inflation coming down and with downside risk as far as growth is concerned, I think there is room to make the real interest rate more accommodative to economic growth without scaring the hawks away.
One reply on “[2554] Is the real interest rate too high?”
Don’t get too caught up with static analysis. Check the spread between average lending rates and CPI inflation for the last ten years or so. CPI inflation has to fall below 1.2%-1.3% before we’re even at the 10yr mean of the spread. And we’re still below the average spread for 2010.
The somewhat troubling reason why is that lending rates appear to have de-linked over time from interbank and policy rates. Monetary policy is looser than it appears to be going by the policy rate alone.