Disinflation costs, weak fiscal institutions and a non-responsive supply-side are key risks
The formalisation of the new monetary policy framework between the government and the central bank marks the next step in the transition to flexible inflation targeting (FIT) by India. The first step was the acceptance by RBI of the Urjit Patel Committee’s (UPC) recommendations in January 2014: Adopt CPI inflation as the clearly-defined nominal anchor; and a two-year ‘glide path’—8% headline CPI inflation by January 2015 and 6% by January 2016—to prepare the initial conditions ahead of formal adoption of FIT. With this agreement, RBI’s primary goal becomes price stability, while keeping in mind the growth objective; the inflation target in year starting April 2016 and beyond will be 4% (±2%); and achievement of this target, or otherwise, will determine success or failure of RBI’s actions.
Not surprisingly, this has been hailed as an epic reform in Indian macroeconomic policy. As with most reforms, the macroeconomic context acquires relevance for its eventual success. The transition to FIT happens at a time when both domestic and external environments are adverse and uncertain, notwithstanding the fortuitous steep decline in oil prices that has accelerated disinflation. Growth is below-trend; despite what the new GDP series reflect, other indicators suggest substantial over-capacity, weak industrial production and bank credit growth, and considerable distress at the balance-sheet level that is reflected in high bad-asset levels at banks. Although temporarily repaired, the internal and external imbalances are structurally unaddressed: the current account gap remains dependent upon capital flows; sustained financing from export receipts inadequate; and the deficit could enlarge any time imports rebound. Likewise, fiscal balances are still precarious with a low revenue base and lack of subsidy reforms. Finally, global demand is substantially weakened with an uncertain financial environment.
It is against this backdrop that two transformations occurred from January 2014: One, price stability is now the primary policy goal, implying reduced weights on the growth objective in interest rate setting. Two, CPI is the nominal monetary policy anchor against the producer price inflation (WPI) previously. The interplay between these changes and the macroeconomic context provides a perspective on the associated growth sacrifice possibilities. Surprisingly, there isn’t a discussion on the macroeconomic setting or timing of the transition in the UPC report, although it states that output costs of disinflation were balanced vis-à-vis choosing the glide-path or speed of disinflation.
The growth sacrifice, however, may be considerable as this will arise not just from the deflationary bias due to monetary tightening (75 bps over September 2013-January 2014) but also from a lasting or structural increase in the real cost of capital as interest rate setting shifted to a much-higher CPI inflation. This shift, the size of which equals the producer-consumer price inflation gap, constitutes a permanent cost disadvantage to which producers must adjust in the long-run. And it comes at a critically low point of the economic cycle, when firms are the most vulnerable with limited abilities to withstand an enduring shock of this nature. Given the larger significance of cost of capital for manufacturing, the risk is of an unintended resource-shift away from the sector. For manufacturing firms to recover from cyclical and structural shocks of this nature could take long in an environment of surplus global capacity across countries.
Some effects are manifest in the visible deterioration in many firms’ balance sheets, steady rise in bad loans (10.7% of total advances in September 2014 from 10% in March); the feebleness of industrial growth (an average 2.1% monthly in April-December 2014 growth over a corresponding 0.02% last year); weak demand for overall bank credit (5.4% growth over March 21, 2014, to January 23, 2015, against a matching 9.7% the previous year) with prominently pathetic growth in credit to industry (2.6% over March 21, 2014, to January 23, 2015, compared to 8.9% in March 2013 to January 2014).
If disinflation extracts too high a price in the initial stage of FIT, risks to the next phases of implementation could increase. This particularly applies in the case of fiscal policy, institutional support from which is essential for FIT’s success. Fiscal dominance is often a key inflation driver and can negate monetary policy effort, a potential threat to credibility. Adherence to fiscal rules in India is insufficiently entrenched; there is temptation to pause, bend or extend commitments whenever the business cycle wanes, growth slows and tax revenues decline. To recall recent fiscal history, a pause to the consolidation path under the Fiscal Responsibility and Budget Management Act was announced in 2009-10 to combat the crisis shock while return to course was delayed. A revised path to restore fiscal health by 2016-17 was drawn by the Kelkar panel (2012) with the government on course to achieve it since. But in a similar replay, the 2015-16 deficit target (3.6% of GDP) has been raised to 3.9% to address growth concerns.
Then again, overlooking these aberrations and assuming full institutional support by way of tight fiscal rules/commitment that is needed for successful FIT implementation, the required fiscal path could be demanding. Unless growth picks up substantially to relieve the fiscal burden and relaxes budgetary constraints, there could be temptation to delay or breach fiscal targets; or political support for FIT could weaken.
Then, there are the risks from the supply-side, an important source of consumer price shocks.
The Indian political economy, which must adapt itself for monetary policy support, is essentially non-responsive in the sense that reforms to the market structures to allow free and efficient functioning and pricing to balance demand-supply forces have long been postponed or delayed. If supply-side responses are unforthcoming, in conjunction with low-growth conditions at the time of transition, it implies a prolonged burden upon monetary policy that will be forced to remain tighter than otherwise might be the case. The economy could then be locked in a high-interest-rate regime, breaking out from which could be difficult for fear of undermining credibility. Of course, it could also be the case that inflation targeting could itself compel such supply-side reforms.
For India’s adoption of FIT, the growth outcomes are then quite pivotal in the light of these risks.
The author is a New Delhi-based macroeconomist