Testing time may unfold as fiscal dominance returns with vengeance, global trends reverse
. One hopes though it will let the FIT regime continue unchanged as this hasn’t been sufficiently tested—neither over varied business cycles nor against challenging shocks.
The CPI headline inflation target, set at 4% under the new flexible inflation targeting (FIT) framework, is up for review beginning April 2021. The amended RBI Act requires the inflation target be determined once in every five years by the Union government in consultation with RBI. The central bank’s in-house view has been made public in the Report on Currency and Finance, 2020-21—it wants to retain the framework for another five years. As the RBI Governor recently stated: FIT regime has been successful in anchoring inflationary expectations; it should be preserved, nurtured and consolidated. The government, apparently, thinks somewhat differently, as articulated by the chief economic adviser. One hopes though it will let the FIT regime continue unchanged as this hasn’t been sufficiently tested—neither over varied business cycles nor against challenging shocks.
How has the regime performed in a downswing? The FIT regime has barely been tested since it was officially notified in August 2016, barring the recent exceptional time of Covid-19. The output gap during this period was so large—GDP growth actually halved from 8.3% in FY17 to 4% in FY20—that it was easier for the monetary policy committee (MPC) to look through even though inflation expectations had inched up. For the record, in the 54 months since its adoption, CPI headline inflation averaged closer to 4%; more pressingly, it was even lower 3.4% in the first 40 months to November 2019, thus staying mostly within the 2% tolerance band (see graphic).
It crossed the 6% upper bound for the next 12 months, a period largely dominated by Covid-related supply disruptions. With returning normalisation, inflation has fallen back closer to 4%. Therefore, the FIT regime has barely been challenged in its first term, save these incomparable twelve months. This tenure is described by a steady and sharp economic slowdown. Even the exchange rate pressure episode stemming from the global oil-price surge in 2018 was short-lived.
Its smooth sailing though, could be attributed to developments prior to the official August 2016 rollout. It was almost two years before, in August 2014, that CPI inflation fell below 6%, remaining within the tolerance band thereafter. RBI claims it was the signaling effect of regime change in September 2013, the informal rollout in January 2014, combined with some good luck that tamed the beast.
The central bank reports an important counterfactual exercise which tells us that had CPI inflation been the nominal anchor in the 2009-11 high inflation phase, the policy rate would have been tightened much earlier, not allowing inflation expectations reach high double digit.
Now this might have been true, but it is far-fetching to claim the IT regime (informal one) led to collapse of inflationary expectations within a quarter—from 13.5% in September 2014 to 9.3% in December 2014! In fact, RBI had announced a disinflationary glide path for lowering CPI inflation to 8% by January 2015 and 6% by January 2016. Much to its surprise, though, inflation declined to 6.8% in June 2014 and 5.6% by September 2014, a full sixteen months ahead of time!
What these narratives also do not tell you is that WPI inflation had fallen under 5% in April 2013, turned negative by November 2014. A larger divergence between WPI and CPI was untenable and CPI inflation would likely have fallen anyway, irrespective of whether there was FIT or no FIT regime!
Are inflation expectations well-anchored? The moot point is whatever may have happened in the past, has monetary policy gained credibility to anchor expectations in the last five years? Without doubt, professional forecasters’ expectations have been fairly aligned like many other IT economies. But the survey-based, households’ inflation expectations (both 3-month and 1-year ahead) tell a different story (see graphic): These have never fallen below 8%, swinging in the 8-10% region through these 54 months. When expectations suddenly collapsed in December 2014, RBI was quick to claim early success. Stuck above 8% since then, the focus was shifted to their direction and away from level!
The RCF draws attention to some other countries where household inflation expectations remained above-target in the initial years and took long to align. But India’s urgencies were different: it is critical to recall the entire edifice of the Patel Committee was based upon anchoring household inflation expectations that go into wage negotiations and consequent second-round effect.
This was also the reason why core inflation in India converged towards the headline, compelling the committee to recommend targeting headline inflation, contrary to other countries. Indeed, there could be several sound and alternate reasons why persistently high household expectations have not led to a wage-price spiral after 2014: a large output gap, then statistically measured; high unemployment rate relative to pre-2014 period; increased manufacturing capacity slack confirmed by RBI surveys; low producer-price expectations captured in WPI; lower productivity growth; and weak bargaining power with increasing casualisation of labour. With expectations of a cyclical recovery, things could change.
Has macroeconomic stability been secured? If one recalls developments in 2018, it is easy to see how fragile India’s external account is to oil-price spikes. The current account deficit rapidly expanded within few quarters, pressuring the exchange rate, notwithstanding the level of forex reserves and actual capital outflow. What then saved the day was a modicum of fiscal discipline, weak private investment demand and extraordinary supply management efforts to restrain food prices. Now, global commodity and oil prices are on the boil once again after their collapse in 2014 and rekindling cost-push elements. Domestic agricultural marketing reforms could also impart some price volatility. With the return of fiscal dominance to revive post-pandemic growth, we are back to square one.
For more than a decade since the 2008 global financial crisis-induced recession, most advanced economies are experiencing what can be aptly described a period of ‘Inflation Drought’. From the euphoria of success in taming inflation below 2% target, the situation has fast degenerated into growth pessimism, reflected in concerns like secular stagnation or Japanification. Post-pandemic, many of these countries are trying to reflate their economies out of the slumber. It is too early to gauge if these policies will spark inflationary pressures or even if they do, inflation will sustain. But the recent turbulence in bond markets could be an early indicator of a period of volatility in international financial flows.
It is to be hoped these developments are a fleeting phenomenon. If international oil and commodity prices continue to move up and bond market rout festers, then emerging market economies like India could face extreme uncertainty and capital outflows. This may not augur well as the shadow of fiscal dominance, on which the central bank has gone silent, returns with force. As RBI prepares to facilitate huge government borrowing programs for the next several years, the situation could soon be ripe for testing times for the FIT regime.