Global commodity prices have retreated in recent weeks. The result: Indian policymakers seem to have begun to tweak the commodity price assumptions on which their policy targets are based. Consider these two facts.

First: Arun Jaitley presented the national budget in July. His estimates of the fiscal deficit, and specifically the fuel subsidies bill, were based on the assumption that global crude oil prices would be at around an average of $110 a barrel till April.

Second: The Reserve Bank of India (RBI) tabled its first analytical report on inflation in September. The Indian central bank said its inflation forecasts have a baseline assumption that global crude prices would be below $100 a barrel for the rest of the fiscal year.

It is not hard to guess why there is a $10 a barrel drop in the assumed global price of oil in policy calculations. The recent fall in these prices will alter terms of trade in a manner that will benefit a net commodity importer such as India. After all, Indian commodity imports as a percent of gross domestic product are almost three times as large as commodity exports.

Several investment banks have already quantified the extent to which a decline in global crude oil prices will benefit India in terms of inflation, the fiscal deficit and the current account deficit. There is growing confidence that the Indian government will be well placed to meet its budgeted fiscal deficit target while the Indian central bank seems to be on track to meet its immediate inflation target for January 2015.

This comes in the wake of a long period when successive governments rarely met their fiscal deficit targets while inflation drifted outside what the Indian central bank considered its zone of comfort. Such an inability to meet policy goals has damaged the credibility of Indian economic policy. The recent hopes that policy targets will be met this year should be seen as only the first step in a long journey towards making policy more credible.

Consider the fiscal record first. Finance ministers almost create fiscal numbers out of thin air. They consistently overestimate revenues while underestimating expenditure. An analysis of budgets over the past 25 years by economists Deepa Vaidya and K. Kanagasabapathy of the EPW Research Foundation shows this very clearly. The result: the final numbers for fiscal and revenue deficits are higher that what was originally budgeted. The Indian government has also consistently missed its medium-term fiscal targets since 2009.

Now take a look at what has happened on the monetary policy side. Inflation has been above target for most of the past six years. One indication of how this has damaged the credibility of monetary policy statements is to be found in the (admittedly imperfect) inflation expectations surveys conducted by RBI. The latest results show that Indian households continue to expect double-digit inflation despite the clear signs of ongoing disinflation. It may be worthwhile for some economic researcher to check whether there is any other country with such a wide divergence between actual and expected inflation.

Why is policy credibility important? Contemporary macroeconomics has laid a lot of stress on issues such as expectations, time inconsistency, communication and reputation—and shown how weak credibility reduces into the effectiveness of policy. One does not have to be a registered member of the macroeconomics consensus that is now under attack to notice that credibility is important. A simple example: inflationary wage demands will continue to increase even when the central bank with weak credibility says it is committed to disinflation because workers expect future inflation to be much higher than what policy makers are promising.

This column has even earlier argued that India needs a new institutional structure to help make its economic policy more credible.

On the fiscal side: a new law to restrict government deficits on the lines of the abandoned Fiscal Responsibility and Budget Management Act as well as an independent fiscal watchdog on the lines of the bipartisan Congressional Budget Office in the US.

On the monetary side: the Urjit Patel committee has already suggested that consumer price inflation should be the official nominal anchor of Indian monetary policy. Newspaper reports also suggest that the government is moving towards deciding on a new monetary policy framework for the Indian central bank.

Both strong fiscal laws as well as the primacy of inflation targeting have many vocal critics. The point right now is not whether there should indeed be constitutional limits on government deficits or whether a sharp focus on inflation control is indeed superior to the more eclectic mix of monetary policy targets. The point is that policy credibility has been damaged in recent years for a variety of reasons. The challenge is to create a new set of rules that keep fiscal and monetary policy on the path that has been communicated to citizens.

Niranjan Rajadhyaksha is executive editor of Mint.

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