The Reserve Bank of India (RBI) Governor on January 16 announced the first rate cut after a gap of 20 months. The guessing game now is how many more rate cuts we can get.

Savings can rise only if a saver gets a real return, that is nominal interest rate minus inflation must be positive but how high should the real interest rate be?

If nominal rates, that is the repo rate is at 7.75 percent and inflation is expected to be 5.5 percent average in 2015, it gives a real rate of 2.25 percent. Is this too high? Will savers be content with 1 percent or 2 percent real rate?

Dr Rangarajan, Former RBI Governor and proven inflation warrior in India, Jahangir Aziz, Chief Economist, JP Morgan and Eswar Prasad, Professor of Economics from Cornell University, discuss on the same.

*Below is the transcript of the interview with CNBC-TV18’s Latha Venkatesh*

**Q:** What do you think should be the real rate in India? Will savers be content with one percent?

**Rangarajan:** There is no easy way of determining it. There is a proof in economic theory that in a purely closed economy the real rate of interest can be equal to the real rate of growth of the economy. Therefore it can go as high as that but this is not valid in an open economy. That holds good purely in a closed economy.

Everyone realises that savers particularly need a real rate of return on their deposits or on their assets. Therefore in some sense it depends upon the level of savings that one wants to have in the country. If the demand for savings is higher then obviously we should be willing to pay a higher real rate of interest. I certainly think that an Indian investor, or Indian saver is really looking for a real rate of return which is above 2 percent, I think it is closer to 3 percent. This again is a guess, there is no way of purely determining it but if you want actually a higher level of savings in the economy we should work towards something like close to 3 percent real rate of return as far as the financial assets are concerned.

**Q:** In that case if the informed guess of average inflation for 2015 is 5.5 percent then your 2.5 percent would mean that we are already not giving a very good real return at 7.75 percent. At least we should not give too many more rate cuts, lest we scare away savers.

**Rangarajan:** The average of 5.5 percent is something that we need to re-check. In fact all projections of RBI on this core have gone awry. The inflation rate today is way below the glide path that was indicated. Therefore one could expect the inflation rate to be somewhat lower than the number that you are talking about. After all if you look at it in terms of the wholesale inflation, that is fairly low and I do not think that probably we are looking for 5.5 percent in the coming year. It will be lower than that and therefore that further cut in repo rates are possible. Anything should be done in relation to what is happening actually at the ground level.

My own expectation is, given the way in which inflation has behaved in the recent period perhaps we might be closer to between 4.5 and 5 percent on an average. Therefore even if you have a 2.5 percent real rate of interest, it is something like 7 percent. Therefore there is certainly a leeway to go. There is possibility of further reductions up to a total of 100 basis points during the year.

**Q:** Is there a real rate which is common across countries?

**Aziz:** No, because your real rate is essentially determined as Dr Rangarajan said, more or less in the medium term by your real growth rate. The nominal rate of course will equalise across countries if you have open capital markets which means that inflation adjusts so that your real rate and your real growth rate more or less has some sort of a relationship over a average over the medium term.

**Q:** Now, let’s come to India, what would you say is the good real rate for India?

**Aziz:** The way in which we would want to look at this thing is, let’s pick up a time period in India where we think things were stable and I want to use the word normal but just can’t use the word normal but more or less stable. So, you had really decent growth rate, you had a pretty stable inflation rate, the current account deficit did not blow up , the rupee more or less was stable etc. So, broadly we are talking about that period, 2003 -2007, not even 2008 and if you look at that period of time, potential growth probably at that time was about 8.5 percent and if you look at real policy rate at that point in time that is where you get that 200 basis points or 2 percent real rate. That is where you want the policy rate to be.

Without going into 5 percent, 5.5 percent, what will be next years’ interest rate, let’s take 6 percent which is their target and 4 percent, the target after 2016, which is where they really want to be. You take an average of 6 percent and 4 percent you get that over the medium term if RBI more or less manages to keep the inflation expectation under control, they will keep inflation around 5 percent. So that is where you get a 7 percent nominal policy rate. Now, 2 percent real plus 5 percent inflation gives you a 7 percent nominal policy rate. You are at 7.75 now, the question is that do you want to give the entire 75 basis points now or do you want to even give more than 75 basis points. In other words you want the real rate to be even lower, why because growth is actually lower than the potential growth rate right now, hoping to make it up later on. So that is the way you calculate it.

**Q:** Let me get Dr Rangarajan’s response on this.

**Rangarajan:** When you talk about the real rate, there is not one real single real rate. You are talking about the real rate for the policy repo and there is a real rate for long term savings. When I talked about 3 percent as the real rate of interest I am thinking in terms of the long term savers, whereas the repo rate is basically a rate which is your short term interest rate. Therefore we need to make a distinction between the real rate of interest for a short term transaction and for medium term and long term transactions. Therefore 3 percent real rate of interest for savers is appropriate and perhaps the policy rate need not necessarily have a 3 percent real rate of interest.

**Q:** Since you were instrumental in bringing down the inflation level from double-digit levels in your own time, the RBI has take a fairly ambitious target of 4 percent inflation as suitable or as possible for India. If you compare this to the historical rate of inflation in India, the average of 70 years is 7 percent if you looked at the Wholesale Price Index (WPI) almost 6.9 percent. If you looked at consumer price index (CPI) industrial workers, then the average has been actually 8 percent. Do you think it is too tall a ask of 4 percent that the Urjit Patel report has set for next year? Is the political economy too comfortable with that 7 percent inflation and therefore it will resist 4 percent?

**Rangarajan:** There are two types of answers to your question. First is that the very high inflation rate that you have got or that you have calculated is over a very long period. There was a period in the Indian history, in the post independent period when many people talked about inflation almost being endemic in economic growth. It is this which led to very sharp increase in prices. You remember in mid 1970’s, the wholesale price inflation not only touched double digits, it went almost up to 20 percent. Therefore those days are gone and if you naturally look at after 1992-1993 or 1993-1994, the level of inflation is much lower on the wholesale price index. Therefore it is possible.

The other answer is that while 4 percent is the desired level, the argument is that it could range in a zone of 2-6 percent. 2 percent let us leave it out, let us look at the upper end of the zone, it is 6 percent. Therefore strong action is required when the inflation rate actually exceeds 6 percent. Therefore I would think that yes, 4 percent is the most desirable level but actually strong action is required when it exceeds 6 percent. If you look at it that way, I do not regard the target set as being ambitious and it is most desirable to achieve it because world over the inflation has come down and India cannot be an exception to that.

**Q:** My question is the political economy appears to be comfortable with 7 percent inflation, so will it resist actions towards 4 percent?

**Aziz:** My guess is that 7 percent inflation rate with which the political economy, “was comfortable with” was when growth was also 8.5 percent. You now no longer have the luxury of 8.5 percent growth rate so that real incomes were pretty large and growing very fast. If your real growth rate is now down to 6-6.5 percent, I really don’t think that the same population would now be willing to live with a much higher inflation rate than let’s say a 4 or 5 percent.