Beware the siren calls
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These are interesting times for those who care about how economic policy is crafted.
The monetary policy rule book has just been rewritten. And fiscal policy rules could be overhauled by the end of the year. What now needs to be closely tracked is whether the Narendra Modi government will fall prey to the siren calls for a higher inflation target as well as a bigger fiscal deficit—moves that will push economic growth in the near term but could set India up for another round of economic instability in the longer run.
The government has over the past few days notified important changes to the Reserve Bank of India Act. The finance ministry will now give the Indian central bank a formal inflation target once every five years. The actual decision on interest rates will be taken by a monetary policy committee (MPC) rather than the governor alone. The committee will have to explain to the government in case it fails to meet the inflation target for three consecutive quarters.
There is still a very important ambiguity. What level of inflation will the government ask the Reserve Bank of India (RBI) to target? The future trajectory of interest rates will depend on the answer to this question. A higher inflation target will mean that the Indian central bank has more room to cut interest rates in the quarters ahead.
The monetary policy agreement signed earlier this year between the finance ministry and RBI states that the inflation target for fiscal year 2017 “and all subsequent years” would be 4% with a band of plus/minus 2%. But the recent notifications do not specify the inflation target. Will it be the one agreed upon earlier this year? Several people have told me that the finance ministry will settle for a higher inflation target—perhaps a percentage point higher than the existing target—but first discuss it with the next RBI governor. The upper end of the band could then be consumer price inflation of 7%.
Now, let us shift to fiscal policy. A new committee headed by veteran bureaucrat N.K. Singh has begun its task to map out the contours of a new fiscal law that will replace the landmark Fiscal Responsibility and Budget Management (FRBM) Act, introduced by the Atal Bihari Vajpayee government in 2003. Many countries are re-examining existing fiscal laws that give a hard fiscal deficit target, independent of the state of the underlying economy. First-generation fiscal laws were developed at a time when the Great Moderation raised false hopes that extreme economic cycles were history.
What could replace the FRBM targets? One option is a flexible fiscal deficit target that is adjusted according to the state of the economy, based on potential output rather than actual output. So, the government will be able to run an aggressively expansionary fiscal policy during a sharp downturn, something that the existing fiscal rule does not allow.
There is a problem here. Potential output is not a directly observed variable; it is a statistical estimate. The rate at which an economy can grow without breaching its inflation target—aka potential growth—is calculated using either a range of filters or with a production function. Every economist has his own estimate.
The credibility of fiscal policy could be damaged if the financial markets do not agree with the official estimate of potential output and growth. Some may even accuse the government of fudging the numbers. It is thus very important that an independent fiscal council, such as the bipartisan Congressional Budget Office in the US, is set up to provide an independent analysis of the budget numbers, especially when the fiscal deficit target is based on potential output. This column has called for a fiscal council on three earlier occasions, and I will revisit this issue in greater detail later.
Indian economic policy has been on a slippery slope. Governments first push expansionist policy by embracing fiscal profligacy while piling intense pressure on RBI to keep interest rates low. Inflation begins to climb. The current account deficit widens. Investors eventually lose confidence in the rupee. It all comes together in a crisis.
The last time this happened was during the run on the rupee in July 2013, as high fiscal deficits and double digit inflation eventually pushed India to the brink. Then the lesson sinks in. The government of the day begins to stabilize the economy. Interest rates are increased to bring down inflation. The fiscal deficit is cut. The economy stabilizes. And that is the usual cue for a revival of the belief that higher growth needs expansionary policy rather than economic reforms.
Are we on the verge of another turning point? The answer will be clear only after a new inflation target is decided and the new fiscal law is crafted. Meanwhile, here are three data points. India is perhaps already growing close to its potential. Indian inflation is 2.5 percentage points higher than its peers among Asian emerging markets. And our consolidated fiscal deficit is the highest among the major economies.
Niranjan Rajadhyaksha is executive editor of Mint.
Read Niranjan Rajadhyaksha’s previous columns here