Is a tighter monetary policy on the cards?
Here’s the reason for that question: For the Consumer Price Index (CPI)-based inflation to decline to the Reserve Bank of India’s (RBI’s) medium-term target of 4%, non-food, non-fuel—or core—inflation must slide to 3.8% from around 5% now. And that’s assuming food and fuel inflation stays at around 4.4% and 3%, respectively, which is the average so far in fiscal 2017.
That’s a tough ask, given that core inflation has never fallen that low for a sustained period of time. Demonetization brought CPI inflation down sharply to an average 4.6% in the 11 months of the current fiscal year. But that’s about to reverse with rising upside risks to fuel and food inflation, and the impact of demonetization fading.
We foresee CPI inflation averaging 5% in fiscal 2018. While that’s still within the 4% (+ or - 2%) range set by the government, it is higher than the 4% central value that the central bank is now targeting. Achieving that on a sustained basis will, therefore, mean continuation of the non-accommodative fiscal stance, and perhaps a tighter, and more disinflationary, monetary policy over the medium run.
To be sure, current CPI inflation is over 500 basis points (bps) below the peak of 10.2% seen in fiscal 2013 (one basis point is one-hundredth of a percentage point). But core inflation, which measures demand-led inflation, has not fallen as much despite sluggish demand and capacity utilization. On the other hand, in some sectors, demand seems to outpace supply.
What gives? Are monetary and fiscal policies not tight enough? Or is their mix ineffective? The repo rate has already been slashed by 175 bps since January 2015, and the fiscal deficit ratio is close to the desired 3% of gross domestic product (GDP). In other words, there’s little leeway to reduce the fiscal deficit further.
That would mean the burden of maintaining 4% inflation will continue to fall on monetary policy. But that will be a suboptimal solution, as a tight monetary policy may not bring down the sticky part of core inflation, and we may end up reducing demand in sectors with excess capacity that respond to interest rates.
There’s another catch. About 38% of core inflation comprises items in chronic shortage, which translates into perpetual upward pressure on inflation. These include health, education and housing. Given severe shortages, especially in public health and education facilities, most people turn to the higher-cost private sector. Monetary policy can only play a limited role in such sectors, as demand in health and education is less sensitive to prices and interest rates. Inflation control in these categories is thus a function of fiscal policy—about reorienting government spending towards supply expansion.
The rest of the core index comprises items where inflation is more demand-led.
Here, a large part includes consumer services such as household services, transport and communication, recreation and amusement, and personal care. An RBI study (Exploring The Slowdown, 2002) finds that in the case of consumer services, demand has unit elasticity to income. A tight monetary policy will be more effective in trimming demand, and therefore inflation, in these categories.
Over the past four years, inflation in products suffering from persistent supply shortage fell only 230 bps, whereas those where income-led push to demand has a larger role to play slid nearly 400 bps. That means a disinflationary monetary policy will have limited impact on core inflation.
So what can fiscal policy do? Fiscal spending remains skewed more towards consumption than investment. Consumption spending now comprises 83% of total spending, up from 78% a decade ago. Any further increase, even if moderate, is bound to push up consumption demand rather than augment production capacity, and therefore stoke inflation.
The budget for fiscal 2018 tried to correct this imbalance with capital expenditure budgeted to grow at 10.7% compared with revenue expenditure, which is set to grow 5.9%. This trend needs to continue in future budgets, too, for a material correction in the expenditure skew.
The onus of lowering inflation—and keeping it there—is now as much a fiscal goal as it is a monetary policy goal. Fiscal spending with a focus on capital formation should target sectors where supply is a constraint and demand high—or in health, education, even agriculture.
Even then it will take time to rein in inflation in these areas. For example, agriculture (or food) inflation can be classified as persistent, where “noise” quickly morphs into generalized price rise. Sure, a 4% CPI inflation goal is a desirable goal, but trying to achieve it in a short span of time can have a nasty side effect: a disinflationary bias in monetary policy.
As noted economist Vijay Joshi in his book, India’s Long Road: The Search For Prosperity, writes: “The output cost of bringing down inflation may well be greater in the future than in the past. In other words, India will unavoidably face a sharper short-run trade-off between inflation and growth than hitherto.”
That could well be the case, at least in the near term.
Dharmakirti Joshi and Dipti Deshpande are, respectively, chief economist and senior economist at Crisil.
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