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Saturday, January 28, 2023

It’s too risky to revert so slowly to policy as usual

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It’s obvious why fiscal and monetary policy both had to shift into rescue mode after covid bared its fangs in 2020 as a threat to the Indian economy. In contrast, the pace at which policymakers must return to post-pandemic normalcy faces an admittedly tough trade-off. Go too fast, and our economic recovery could flag, a fear fanned by last quarter’s weak factory output. Go too slow, and we risk a prolonged period of sub-par growth, a problem that can arise from a slide-back on macro management reforms. Now that fiscal dominance has staged a dramatic comeback for three covid-stricken years, with demand and supply crawling more or less back to past levels, the monetary policy of the Reserve Bank of India (RBI) has no choice but to take its primary cue from the Centre’s deficit plans. Alas, we know rather too little. The finance ministry’s signals suggest that it is aiming for a fiscal gap of 4.5% of GDP by 2025-26, well above the pre-covid target of 3% officially held as optimum. With no new price-softening factors in play, a big-government fisc would force RBI to keep credit tighter than otherwise, given that it was tasked in 2016 with keeping retail inflation at 4% (or 6% at most). This is a target RBI failed this year. Should it fail again, it would deprive this reform of credibility, perhaps even undo the boldest macro move made by the Narendra Modi administration so far. But then, RBI could yet prove its mettle on price stability.

A recency bias tends to attend discussions of policy rates of interest. Especially salient in recent days has been word from the US Federal Reserve that it may moderate its rate escalation a bit, having gone in for a steep incline this year in response to flaring US prices. Since tighter money operates with a long lag as it cramps credit and dampens demand, the Fed may have good reason to decelerate its tightening. To the extent that a rate differential with America impacts our capital inflows (and rupee), that would hold some relevance for RBI’s monetary policy panel. But we cannot assume similar inflation dynamics in India. The lag with which rate tweaks take effect is usually longer here, the job scenario hardly matters, and we have a jumble of rigidities that can make it harder to get a handle not just on prices stiffened by supply snarls, but also on core price instability (not counting fuel and food, i.e.). If price control is the de jure and de facto challenge, then RBI must go chiefly by domestic inflation concerns.

While bankers have aired expectations of a 35-basis-points hike in RBI’s repo rate after three successive 50-basis-point hikes, with a manufacturing slump cited alongside its within-range inflation forecast for early 2023-24 to justify this, a premature let-up would risk going too slow on an easy-money reversal. For one, RBI’s inflation outlook has been unreliable. For another, a repo rate upped to 6.25%, say, would only be slightly positive in real terms even if we can count on RBI’s projection of an inflation dip next year. Even by a flexible interpretation of the Taylor Rule, this would still spell a policy meant for easy lending. Neutrality would call for a rate that’s clearly above trend inflation, its bar set sufficiently high for real returns on investment to attract funds, but without letting overly risky speculation run rife and dubious asset bubbles inflate. Crucially, we must not let loose fiscal and monetary policy snuff out the hope of a low-inflation economy. Let covid not be a pretext that makes space for cynicism over public debt piled up only to be inflated away. We need an orderly return to policy normalcy.

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