The textbook answer to economic downturns is simple: When the economy suffers from low demand, reduced capacity utilization and high unemployment, the central bank should cut interest rates. When interest rates are cut, households and businesses begin to borrow, spend and invest, thereby raising the overall demand in the economy. When businesses see higher demand, they hire more workers to meet it, thereby reducing unemployment. Although the process takes a year or so to have its full impact, it tends to work faster than fiscal policy.

A fiscal stimulus takes a long time to materialize, and it is difficult to undo, thereby permanently raising government deficits and debt. The current crisis, however, is far from normal. Some fear that central banks are almost out of ammunition. Hence, fiscal policy has been pressed into action the world over.

Excessive fiscal expansion financed through market borrowings, however, raises interest rates, potentially undermining the recovery in private consumption and investment expenditure, which are necessary for sustainable economic revival. This has plausibly happened in India, too. Although the policy rates were gradually reduced until April of this year, the risk-free rate which determines the floor for the long-term lending rates (yield on 10-year government securities) has been steadily rising since October 2008 as a result of an expanded government borrowing programme. The latest figure for private consumption expenditure suggests that growth slowed to 1.6% year-on-year during April-June 2009 compared with 4.5% the same quarter last year.

Illustration: Jayachandran / Mint

To begin with, let us note that it is the real long-term interest rate which determines how much households and firms borrow. It is defined as the nominal risk-free rate minus expected inflation plus risk premia. Central banks in countries such as the US and Switzerland had cut their short-term nominal interest rates to near-zero by December 2008. Even as central banks started injecting liquidity through unorthodox means, it soon became clear that the real interest rates—both at the short and long end of the term structure—were still relatively high either because risk premia remained stubbornly high or because inflation expectations were too low or both. This, in turn, set the stage for fiscal policy.

Fiscal expansion, coupled with loose monetary policy, does not put upward pressure on long-term nominal interest rates, but rather raises inflation expectations to its desired level, thereby reducing real long-term rates. This is because when policy rates are sufficiently low, the market is led to believe that the demand slowdown is significant enough and that expected inflation is at a lower-than-desired level.

In contrast, if policy rates are relatively high prior to the fiscal stimulus, the private sector is led to believe that the central bank is in fact worried about the inflationary outlook going forward. Under such circumstances, fiscal expansion tends to significantly drive up not only inflation expectations, but also the (expected) long-term interest rates as the market expects the central bank to tighten its belt soon. Doubts about servicing public debt at relatively high interest rates lead investors to demand even higher premium on government securities. This further steepens the yield curve.

In the light of this discussion, we can now examine if monetary policy was sufficiently loose prior to the fiscal stimulus in India. In response to the global crisis, the Reserve Bank of India (RBI) aggressively cut its key interest rates (as well as the cash reserve ratio) since October 2008. Out of a total reduction of 4.25%, only a 2.5% reduction in the repo rate came before the announcement of the first fiscal stimulus plan in December. The initial monetary stimulus led to a significant softening of short-term as well as long-term risk-free rates. As government market borrowings began to increase, however, the 10-year paper started to rise sharply, even as RBI continued to reduce its rates and announced other measures to accommodate the government’s borrowing programme.

An obvious question is whether the inflation outlook at that time allowed RBI to slash policy rates further. Headline inflation was hovering around 10% in October last year, but forecasts available at the time, such as the survey of professional forecasters conducted by RBI in the October-December 2008 period, suggested that the Wholesale Price Index (WPI) inflation would moderate to 0.4% by July-September 2009. Even though the Consumer Price Index (CPI) continues to languish above 10%, monetary policy has little ammunition to curb it. High agricultural prices (which constitute nearly 46% of CPI) are mainly due to supply-side bottlenecks owing to the failed monsoon and the general absence of reforms in the agriculture sector.

No one can be sure, but in all likelihood, had monetary policy been sufficiently loose prior to the fiscal expansion, the 10-year government paper rate, the floor for the lending rate today, could have been lower. Had this happened, private consumption could have recovered relatively quickly. Moreover, we might have required a lower dose of fiscal expansion which would have left some headroom to handle unforeseen shocks such as the recent monsoon failure.

In sum, the sequencing of monetary and fiscal responses is critical in stimulating the private economy. Fiscal expansion is less effective if monetary policy is not sufficiently accommodative to begin with. It is an altogether different question whether fiscal policy is a potent weapon to fight a downturn when there are doubts about long-term fiscal sustainability.

Vidya Mahambare is senior economist at Crisil Ltd. Views expressed here are personal. Comment at