The fiscal dominance trap
Last week, the committee appointed by the Reserve Bank of India (RBI) to recommend a monetary policy framework submitted its report to the governor. By now, most analysts have gone into its salient aspects. These include the choice of the target, the appropriate measure of inflation, the numerical target and the timeline to get there. There is not much scope to find fault with the committee’s deliberations or conclusions.
Most of us are aware and the committee, too, is aware that post-2008 many countries have recognized the need for a flexible approach to monetary policy even though they may not have formally abandoned their goal of an appropriate inflation rate. The committee has taken note of that and suggested the deployment of additional macro-prudential measures such as provisions, loan to value ratios, etc., to go along with monetary policy measures. Therefore, this columnist shall reserve his scepticism of inflation targeting for developed countries and will accept that, in the present Indian context, stabilizing the inflation rate in India is paramount and urgent.
The committee has said that when the rate of inflation is above the nominal anchor, real rates should, on average, be positive. The committee’s recommended nominal anchor is an inflation rate of 8% for the first year of the inflation targeting regime. The current rate of inflation, at nearly 10%, is well above this target. The repo rate is 7.75%. Hence, the real rate is negative. Therefore, if RBI has taken on board the committee’s recommendations and is to implement them straightaway, the policy rate has to go up substantially. That is unlikely. At the same time, the submission of the report with its implication for higher policy rates means that the central bank is unlikely to drop rates. Recent developments in emerging economies and in the global financial market place too preclude that.
In chapter IV, the committee suggests that the liquidity management operations of RBI should be consistent with the stance of the monetary policy (para IV.29). It is both reasonable and important. In para IV.27, the committee notes the conclusions of a RBI working paper that monetary policy transmission in India is more effective during the liquidity deficit mode as compared with the surplus mode. In the light of this, it is important that the monetary policy committee errs on the side of being early with its macro-prudential measures when capital inflows threaten to undo the transmission from a tight policy setting. In other words, the committee should lean than to wait to clean (phraseology courtesy William White). Of course, capital flows are not an immediate “threat” to India or, for that matter, to emerging economies for now.
Of course, yours truly does not agree that the high Consumer Price Index inflation rate of the last several years has discredited the “multiple indicators” approach followed by RBI. The high fiscal deficit has resulted in the fiscal dominance of monetary policy with its inevitable monetization of the government deficit. Whether it likes it or not, the central bank is forced to hold government securities, as institutional investors are correctly reluctant to hold government securities with persistently negative real yield. That is reflected in the liabilities side of the balance sheet of the central bank with its equivalent money creation. India’s inflation problem is thus one of fiscal deficit and its inevitable monetization. Without a concurrent credible commitment on the part of the government to bring down the deficit, monetary policy in India will fail to deliver on the inflation goal.
In this context, the committee has made many worthwhile suggestions to which India’s political class must agree immediately, in the interests of the nation. The submission of a report by a committee of the central bank on the monetary policy framework might appear to be an esoteric or obscure event for India’s prime ministerial aspirants to reveal their “economics” cards. But that would be a wrong conclusion to make. The most visible manifestation of the UPA regime’s non- and mal-governance of the last decade has been the relentless increase (and still rising) in cost of living. What the committee has proposed is, hence, of utmost importance to the common man and woman of India.
The committee has deliberately come up with an inflation target by itself and left out government nominees on the monetary policy committee. Now is not the time for the executive to engage in balance-of-power battles. It is important to restore the sanctity and primacy of institutions that the UPA government has systematically and considerably eroded in the last decade. Fiscal dominance of monetary policy has to end. Hence, the major political parties must pledge not to fight the committee’s recommendations and not to interfere with commercial decisions of public sector banks to start with.
Their support to the proposals of the monetary policy committee of RBI will be a down payment of their commitment to steer the nation’s politics and governance away from “business as usual”.
V. Anantha Nageswaran is the co-founder of Aavishkaar Venture Fund and Takshashila Institution. Comments are welcome at email@example.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk