The neutral real interest rate could be found at full employment....

INDIA has a flexible inflation target of 2-6% than the US’ 2% target which gives it flexibility to maintain interest rate and the financial stability to manage trade cycles to curb exuberance and excess volatility. The central banks use higher borrowing cost to reduce demand by lowering employment, but this reduces supply too because of less employment and production; in short higher rates would reduce the demand for labour to reduce wage inflation and commodity inflation, mainly, and that may lower demand and prices and interest rate expectations which might kick back demand, inflation and interest rate up in the next cycle. We see that when the central bank increases interest rate, the prices move in the opposite direction, which could create demand and increase prices and interest rate in the future, in a sense it makes little sense to deviate from the neutral real interest rate at full employment. The economy experiences trade cycles due to the deviation from neutral rate of interest which are cumulative in nature, but the higher wage inflation is like the higher borrowing interest rate to control demand, higher wages would itself control demand for labor after full employment, business would become uncompetitive by the rising wages, they would fear that higher prices would make them lose market share. Notwithstanding, the problem of knife edge might be attributed to double tightening or loosening, tightening in labour market and tightening in the capital market, it could be the reason for excess tightening and loosening or volatility or swings in the trade cycles. But, finding a neutral rate at full employment is important to abide the objectives of inflation targeting. In a flexible inflation targeting framework, price moves in a band, like INDIA, we might expect inflation to move between 2-6%, and stability in the interest rate for financial stability. However, a strict or inflexible target, like the US at 2% might necessitate frequent changes in interest rate and expectation which would produce cycles and corrections, a flexible inflation target would help manage interest rate and expectations better with stability. The RBI may try to maintain stability by communicating that it would hike when inflation is above 6% and it would cut interest rate when inflation is lower than 2%, it must make its’ objective and signal clear to the people so that it produces the desired outcome, but as has already been pointed that deviations from the neutral interest rate would produce trade cycles and corrections. A neutral interest rate might be found at full employment at which prices may move in a band to clear excess demand and supply in the market or economy which needs flexible inflation targeting. A strict inflation target might not let prices move to clear excess demand and supply in the economy. Moreover, lack of updated data on unemployment in INDIA to determine full employment would make it difficult for the RBI to find the neutral rate of interest except the neutral stance. The RBI is shooting in the dark….    

People think that the rate hike would arrest capital outflows and depreciation, but to increases domestic investment and exports a lower rate could help and higher rate would lower domestic investment exports and growth... A lower interest rate or yield would also increase bond prices which would increase capital inflow in debt... Higher yields would make the debt unattractive... it would also help domestic investment in stocks... Cheap foreign money had been a prime cause of higher investment in the emerging markets therefore cheap domestic investment should replace cheap foreign investment...