BackInflation targeting fiscal policy
India needs an inflation targeting fiscal policy. Mere monetary actions won't work.
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Inflation has become the buzzword in recent times in India. It is interesting to note the symmetry between inflation and corruption as political weapons, so to speak. Both are handy tools for opposition parties to beat up governments.
The results of recent national and state-level elections have also indicated that price rise is the single most important factor that influenced the voters’ decisions. Relentless media coverage about inflation has added to confusion about the phenomenon, the causes attributed for its existence and the effectiveness of policy actions taken to counter it.
It has been pointed out that the lack of clarity in the Reserve Bank of India (RBI) on the monetary policy framework over the years—which enunciates the goals, strategies and operational tactics for this framework—coupled with large fiscal deficits have contributed to the prevalence of high and persistent inflation in recent years. The RBI, in recent months, has declared its anti-inflation stance and has started conducting monetary policy consistent with the idea of a flexible inflation target as recommended by the Urjit Patel committee.
Among the necessary conditions for the success of an inflation targeting monetary policy is the emergence of an appropriately supportive fiscal policy stance. Many academic studies have shown that a prudent fiscal policy enhances the effectiveness of monetary policy in containing inflation, while an undisciplined fiscal expansion increases the costs of inflation targeting.
A moot question in this context is why not have an inflation targeting fiscal policy?
While the new government has promised to bring down the inflation both in its election manifesto and subsequent policy statements, it is not clear whether a particular level of inflation target is driving the policy actions. It is true that the new government has been in existence only for a month or so and cannot be blamed for the persisting inflation over the years. But, it is also true that the incumbent governing-party was in opposition for years observing the wrong economic policies that the previous government had crafted and implemented and is expected to have a clear idea on the different medicine that India needs.
Unfortunately, one does not find policy statements emanating from different organs of the government consistent with the objective of inflation control.
An inflation targeting fiscal policy, in broad terms, means that all government expenditure and revenue generation policies explicitly take into account their inflationary impact. Declaration of an inflation target by the fiscal authorities will highlight its commitment to the cause of price stability and enhance its credibility.
Governments have always considered the enhancement of welfare of citizens via various public work and income transfer programmes without giving attention to their implications to fiscal deficit and macroeconomic stability. They do not consider, for example, that the control of inflation has similar benefit as nominal income transfer in terms of real incomes and welfare without any of the ills associated with leakages in the fiscal schemes. Similarly, an explicit inflation target for the fiscal policy will also bring about automatic co-ordination between RBI and the Union government in dealing with price rise. For example, both RBI and the Union government could agree on a targeted range for inflation with each working within their mandate and with their own instruments.
What are the instruments that government has to explicitly target inflation? First, as is well recognized, one needs to monitor the quantity as well as the quality of the fiscal expenditures. The declaration of the objective of “minimum government and maximum governance" will certainly help in containing unproductive expenditures. Second, rationalization of tax and pricing policies with a view to minimize the cascading effects on the system. It must be recognized that either through the administered or by the support price mechanism or through the indirect taxes on crucial commodities, the government generates significant part of inflation in the system. An inflation target for fiscal policy means the government will have to be guided by the inflationary impact of those policies before enacting them.
Third, the government must recognize that black money within the system is a major source for sustaining inflation even during low-growth situations. It must deal with the on-shore black money with the same vigour as it is trying to deal with the off-shore black money.
Fourth, there has to be a comprehensive approach to deal with supply bottlenecks. Some of these shortages are the natural outcome of the pattern of growth that we have chosen over the last two decades. But some are opportunistic by products of economic choices made in these years. While the latter is a short run problem, the former is a medium to long run problem involving the coordination of the policies of different organs of the government and the choice of the pattern of growth with both having inflationary consequences.
A government interested in controlling inflation will need to declare a comprehensive framework within which an explicit inflation target for fiscal policy is mentioned and how all its policies are consistent with that objective.
Gangadhar Darbha works for an investment bank in Mumbai. These are his personal views.
Comments are welcome at theirview@livemint.com
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