Scope for the RBI to ease rates is “quite limited”, point out Nomura Economics Research analysts
Nomura Economics Research expects a 25bps (basis points) rate cut in Q2 of 2013 from the RBI (Reserve Bank of India) and then rates to remain on hold for some time. Based on Nomura’s year-ahead forecast that the negative output gap (see graph below) will gradually close and WPI (wholesale price index) inflation will be sticky at around 7%, the Taylor rule suggests that policy rates are very close to the neutral rate currently and, in fact, should move marginally higher.
Taylor rules do have limitations, but they reiterate the RBI’s guidance that room for further easing is “quite limited.”
Interest rate implied by Taylor rule = Real equilibrium interest rate + inflation + 0.5*(Inflation gap) + 0.5*(Output gap), where the real equilibrium interest rate is assumed at 1%, desired inflation rate at 5% and potential GDP growth rate is estimated based on the Hodrick-Prescott filter. Estimates beyond Q1 2013 are based on Nomura projections on GDP growth and WPI inflation.
The RBI recently estimated its neutral nominal policy rate at around 6%. This holds when WPI inflation is close to the target 5% and the output gap is zero. It is found that in reality, WPI inflation is around two percentage points above the desired rate, while growth is below potential. The RBI assumes potential output growth at around 7%, but it is believed that it has fallen to 6%-6.5%. Using actual growth and inflation data, Nomura finds that policy rates have broadly followed the Taylor rule.
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