With the Union Budget a month away, the Reserve Bank of India’s third-quarter review of monetary policy clearly spells out the risk to inflation arising out of loose fiscal policy. It says that a large fiscal deficit presents a challenge to “effective management of inflation by monetary policy".

As this column had pointed out on Monday, the last time policy rates were similar to the current rates, during the upswing of the business cycle, was in 2005-06. On 24 January 2006, the repo rate was raised by 25 basis points to 6.5%, the same level to which it was raised on Tuesday. The big difference was that the average rise in the Wholesale Price Index (WPI) in 2005-06 was 4.4%, much lower than inflation at present.

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One of the reasons why inflation is much higher this year could be that the fiscal deficit is higher than what it was in 2005-06. In that year, the Central government’s fiscal deficit was 3.95% of GDP, while it is 5.5% this year. As the table shows, the fiscal deficit fell to a low of 2.56% in 2008-09, a year in which average WPI inflation was 4.7%. There seems to be a clear correlation between the fiscal deficit and the level of inflation. Of course, other factors also matter, such as the big rise in commodity prices that led to the spike in inflation in 2008-09. It’s significant that, in its latest update to the World Economic Outlook, the International Monetary Fund has revised upward its forecast for oil and non-fuel commodity prices and said that the risks are to the upside. All the more reason, therefore, for caution on the fiscal front.

As the monetary policy review points out, “The real measure of fiscal consolidation lies in improving the quality of expenditure. If the government is able to commit more resources to capital expenditure, it will help deal with some of the bottlenecks that contribute to supply-side inflationary pressures."

Not that cutting the deficit in FY12 is going to be easy, without the one-off windfall from the spectrum auction, and with higher food and crude oil prices.

Graphic by Ahmed Raza Khan/Mint

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