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Home / Opinion / Views /  Opinion | Use a bigger dose of fiscal stimulus to combat this crisis

There have been several occasions when the Reserve Bank of India (RBI) has had to confront the dilemma of tackling sliding growth and rising inflation at once. But never quite as acutely as it has had to in its latest monetary policy decision.

An economic recession is “guaranteed" this fiscal year—a rarity for a developing country like India. Yet, retail inflation refuses to climb down into RBI’s comfort zone. The matter is further complicated by a lack of official data on inflation and industrial production, critically for April and May, with the covid-19 pandemic having thrown all movement out of gear.

India also stands out with regard to its inflation path. Elsewhere in the world, inflation is subdued due to low fuel prices and weak demand, but here both core inflation and fuel inflation are high.

So, the latest monetary policy decision was, in two words, fiendishly complicated. RBI decided to play safe and hold interest rates steady, citing inflation concerns. It chose instead to focus on other equally important issues, such as addressing risk aversion in the system, providing relief to small- and medium-sized businesses and banks, and creating conducive conditions for the flow of credit.

To understand the complicated inflation trajectory, let us step back a bit for context, and then take a closer look.

Monetary policy acted as the first line of defence after the pandemic struck. Since then, India has leaned on it far more than on fiscal policy, the more effective but less feasible tool, given the limited fiscal space.

RBI has taken its role very seriously from the get-go. In March, governor Shaktikanta Das said that monetary policy would play an “avant-garde" role and do “whatever it takes" to protect growth from the impact of covid-19. It did live up to its promise. We saw swift rate cuts (totalling 115 basis points since March), massive liquidity infusion, and a sweep of other measures to improve financial conditions in the country.

But little did one expect inflation to let itself in like an unwelcome guest, upsetting the monetary math.

To be sure, the easing path of inflation based on the consumer price index (CPI) was disrupted in April, when the nationwide lockdown was imposed. An increase in petrol and diesel retail prices also contributed. Thereafter, it softened a tad.

Food and core inflation were the two key drivers of June’s broader 6.1% CPI inflation reading. The rise in core inflation, though, is not due to demand pressures as much as other idiosyncrasies, such as a rise in gold, transport and communication prices. Minus these, core inflation is at 3.9%.

Food inflation, generally treated as noise, has a high weight in the CPI inflation basket and is often difficult to predict. But a bumper rabi harvest and good prospects for the kharif crop point to a lowering of foodgrain inflation. Recent news suggests that prices of some vegetables—chiefly tomato and potatoes—have again flared up.

With gross domestic product (GDP) shrinking, price pressures from these idiosyncratic factors are unlikely to morph into sustained generalized inflation. After the global financial crisis of 2009, generous monetary and fiscal stimulus had pushed the economy’s growth above its potential and created a high-inflation environment. That’s unlikely to happen this time.

RBI has not given a numerical forecast of inflation, but stated that it is expected to nudge down in the second half of the fiscal year due to a favourable base effect.

To be sure, forecasts during a crisis are not very reliable and have a short shelf life. Recognizing this, Paul De Grauwe and Yuemei Ji (2020) noted in a Centre for Economic Policy Research discussion paper, “When uncertainty is extreme, prudent central banks should be guided by what they observe, and not by unreliable forecasts."

Crisil expects retail inflation to average 4.7% in 2020-21, with the second half at 3.4%. If it does play out in line with our expectation, there should be a rate cut in RBI’s October policy.

On the growth front, downside risks are unfolding. That the economy will take a hard knock is evident, but we will have to wait till end-August for the latest GDP data to figure the scale of the damage.

The high-frequency data trends—Google mobility indicators, goods and services tax collections, e-way bills, freight movement and so on—that analysts are increasingly leaning on to fill an information gap paint a worrisome picture. After a wobbly recovery post-May, we are moving towards stagnancy at sub-normal levels. No matter any uptick, every sector is still below its pre-pandemic level. The dark cloud is unlikely to pass till the scourge does. Crisil forecasts real GDP to contract 5% in 2020-21, with risks firmly tilted to the downside. Also, this fiscal year, nominal GDP is also expected to shrink—a first since the mid-1950s.

The key risk to our forecast was the pandemic’s unfettered spread, which seems to be materializing. The reintroduction of containment measures, particularly in tier-2 cities, will further depress economic activity. Offsetting this even partly will require a bigger dose of fiscal stimulus. In its absence, monetary policy would have to keep up the heavy lifting. And RBI has demonstrated that its quiver also holds arrows other than interest rates to support the economy.

Dharmakirti Joshi is chief economist at Crisil Ltd.

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