Not much for inflation, but for output, though with considerable lag!
Slowing growth in recent months has led people to expect the Reserve Bank of India to lower interest rates in its forthcoming policy review. The stock markets are up sharply on expectations of a revival in corporate prospects if rates are cut. But how much do rate cuts really help increase output? Do interest rate increases at least manage to quell inflation, as economic theory suggests?
An analysis shows that the relationship between interest rates and output or inflation is not that straightforward. Analysis of data over the past four years suggests that interest rate changes have had little or no impact on inflation, either immediately or with a lag of a few quarters. Interest rate changes do impact output, but not as quickly as stock market investors seem to expect.
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NO QUICK-FIX
Theoretically, interest rates are negatively associated with output, and positively associated with inflation. To explain, low interest rates reduce borrowing costs and thus stimulate private investment, which, in turn, leads to increased output.
At the same time, to reduce high inflation levels interest rates are hiked (in the short run). Increased interest rate induces people to save more and indirectly reduces the money circulation in the economy.
However, monthly data for India in the last 47 months — between June 2008 and April 2012 — shows that the three variables have not conformed to textbook patterns.
For instance, between October 2008 and January 2009, the interest rates were lowered from 8 to 5.5 per cent (consistently every month) to stimulate economic activity. However, the Index of Industrial Production (IIP), a proxy for output, did not show any consistent increase. It, in fact, fell from 146.2 to 144.4.
On the other hand, inflation — measured by the Wholesale Price Index (WPI) — fell consistently during the period from 128.7 to 124.4!
Interest rate tweaks, in fact, seemed to have limited immediate impact on inflation or output for much of the past four years.
In the last 47 months, the RBI has changed interest rate 21 times, of which, two out of three times, interest rate has been increased. However, during the same period, inflation increased 84 per cent of the times from the previous month, while the output index showed increase 50 per cent of the times.
For instance, the average value of WPI during the 47-month period stood at 140.19. During the months in which the RBI changed the interest rates, the average value of WPI stood at 140.2, whilst the average during the rest of the months (when there were no policy changes), was 140.19.
Similarly, the average IIP value (which proxies for output) for the entire period was 158.06, and during months of interest rate changes it was 157.68.
WHAT'S THE LAG?
However, to expect interest rate changes to impact output or inflation immediately may be unrealistic.
Monetary policies, which include interest rate policies, usually operate with a lag. So have interest rates affected other variables with a lag?
The RBI, in many of its releases, including one of its recent working papers, has estimated that interest rate policy changes take about two to three quarters to affect output and inflation.
We, therefore, ran the numbers to verify if interest rate changes impacted other variables with a six and nine-month lag. However, instead of using just the ensuing sixth month values on IIP and WPI, we used the average values of the fifth, sixth and seventh months, to even out unanticipated monthly variations. A similar procedure was used for the third and fourth quarter data (ninth and twelfth month, respectively).
INTEREST RATES, INFLATION
Here we found that, even with a lag, interest rate increases didn't have much success in bringing down inflation or vice-versa.
In fact, the results turned out to be counter-intuitive. Inflation seemed to be higher six months after interest rate increases and lower six months after the cuts! Average WPI value six months following interest rate hikes was 148.29, while the corresponding value was 127.93 during months when interest rates were reduced.
This contradictory pattern is true for the nine-month period as well. Average WPI value nine months following interest rate hikes was 158.49, while the corresponding WPI value stood lower at 131.28 for the months when interest rates were reduced.
It worked for IIP, although with much delay
When it comes to output, measured by IIP values though, there was evidence of interest rate changes having the desired impact. Lagged values of IIP moved in opposite direction to interest rate changes, as theory suggests.
However, the effect on output happened with much delay – much longer than how stock markets instantaneously react to interest rate changes!
It was only with a four quarter lag that IIP responded to changes in interest rates in the expected way.
The twelve months lagged average value of IIP during the months when interest rate increased stood at 157.45, while the corresponding value following months of interest rate decrease stood at 158.34. Until four quarters, the data actually revealed a positive relationship.
The patterns so far suggest that, if the RBI does bite the bullet and deliver further rate cuts in this policy, one can expect an impact on industrial output twelve months down the line. However, in that regard, they might have to keep in mind that “patience is a virtue”.
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