Indian economic policy is coming out of a long credibility crisis. And this overdue journey is important at a time when many economists are expecting a turbulent year ahead for emerging markets. Policy signals work better when they are credible. So what has happened in the past year should be judged quite differently from the usual impatient debates about the next move in fiscal or monetary policy.

Let us begin with the credibility of fiscal policy. India was on course to meet the medium-term fiscal deficit target that had been agreed upon in the bipartisan Fiscal Responsibility and Budget Management Act (FRBM) that was pushed through by the Atal Bihari Vajpayee government in 2003. The splendid economic boom during the first Manmohan Singh government meant that money was pouring into the tax kitty.

Then everything went into reverse gear. The February 2008 budget saw an increase in the fiscal deficit as the United Progressive Alliance began to get ready for the Lok Sabha election that was due in the next year. The sharp decline in economic growth after the North Atlantic financial crisis of September 2008 forced the second Manmohan Singh government to spend in a bid to keep the economy on an even keel. This was part of a coordinated global fiscal expansion that the leaders of most major economies had agreed upon in early 2009.

The Indian economy recovered soon after. But it never got back on the path of fiscal discipline—one important reason why India had to deal with high inflation followed by a run on the rupee in August 2013. The worst years of fiscal profligacy were when Pranab Mukherjee was finance minister.

There were repeated assurances that India would soon get back to the FRBM path, in the annual budget as well as in various committee reports. But nothing of the sort happened. Indian fiscal policy continued to drift, at least till the return of P. Chidambaram to the finance ministry in July 2012.

Consider this example. The Thirteenth Finance Commission, headed by Vijay Kelkar, had suggested in its December 2009 report that India should whittle down its central government fiscal deficit to 3% of gross domestic product by the end of fiscal year 2014. It would seem, given the current pace of fiscal consolidation, that the country is five years off the target. No prizes for guessing what this has meant for the credibility of fiscal policy statements.

Now let us switch to monetary policy credibility. It is no secret that inflation went out of control once the Indian economy recovered from the immediate effects of the financial crisis. Part of the reason was loose fiscal policy as well as the substantial increases in farm support prices.

But loose monetary policy too played its part, as interest rate hikes were delayed for too long. The Reserve Bank of India did not have a formal inflation target then. But it did signal that it was comfortable with a wholesale price inflation level of around 5%. Inflation in those years was nearly double the target. Such a wide gap between what the Indian central bank said and what it delivered dented the credibility of monetary policy. The muddled defence of the rupee in August 2013 made matters worse.

What has happened over the past two years should be seen against this backdrop of weak policy credibility. Finance minister Arun Jaitley chose to stick to the fiscal consolidation path after hitting the pause button last year—and in doing so he chose to keep aside strong arguments for a fiscal stimulus in favour of maintaining policy credibility.

Raghuram Rajan has also had to push back demands for premature interest rate reductions because he has implicitly valued economic stability over monetary stimulus. The Indian central bank has kept consumer price inflation, which is now the nominal anchor of monetary policy, below its January 2015 and January 2016 formal targets. Many may rightly point out that the recent ability to meet fiscal and monetary targets is partly explained by the steep decline in global oil prices. That is true, but it is still to the credit of the policy authorities that they decided to save the bonanza through tax hikes on fuel.

The hard fight to regain credibility should not be ignored. It has far deeper consequences in a volatile world than the immediate attractions of stimulus.

What now? This column has usually taken a hawkish view because of its obsession with the persistent deficit bias in Indian fiscal policy and the strong inflation bias in Indian monetary policy. However, the fiscal commitments of the government as well as the latest inflation data now make a case for more aggressive monetary loosening, both in terms of policy interest rates as well as liquidity available in the money market. That is something I will come back to later.

Niranjan Rajadhyaksha is executive editor of Mint.

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