INSUBCONTINENT EXCLUSIVE:
By Ashima GoyalRules are reversing the relationship between monetary and fiscal policies, from monetary accommodation of fiscal deficits
(FDs) to independence of central banks with restraints on FDs
One reason is theory that defines active or passive policies in the context of their effect on debt, thus giving a long run focus.
The
second reason for the switch to active monetary and passive fiscal policy is freer cross border capital flows, which favour low FDs and
The RBI governor still has a relatively short tenure, but backing from conservative foreign investors, and the threat of outflows, increases
The third reason is historical experience of negative effects of fiscal dominance with passive monetary accommodation.
India also adopted
flexible inflation targeting (FIT) in 2014 following fiscal responsibility legislation (the FRBM Act) enacted in 2003
This valuable strengthening of institutions makes long run consequences of short run actions clear
But just as fiscal dominance led to problems, monetary dominance can lead to sub-optimal outcomes
Any active-passive policy combination may not be optimal for an economy in a growth transition.
In the Indian economic structure, monetary
policy affects demand relatively more than inflation, while fiscal policy has a greater impact on supply side costs and therefore inflation
While both policies increase demand some fiscal stimulus leaks abroad and appreciates the real exchange rate, thus reducing export demand
A monetary demand stimulus becomes more effective, as lower interest rates reduce debt inflows and depreciate the exchange rate.
Moreover,
the interest elasticity of demand rises in liberalised markets
Without cooperation, outcomes can easily result in higher than optimal inflation and lower than optimal growth.
On a catch-up path growth is
likely to exceed real interest rates and expanding this gap is the most effective way to reduce debt ratios
Policy coordination can bring about higher growth and lower inflation
Optimal coordination during transition requires policies to work together to reduce costs
If there is evidence of supply side improvements keeping expected inflation low monetary policy can be accommodative.
A central bank is
ultimately the agent of the voter
If RBI moves too far from majority preferences, there is likely to be a backlash against it
The electoral prospects of a conservative government facing low growth and employment could weaken
In a rules framework, during overall macroeconomic stabilisation there is little space available to each policy
So it is important that whatever is there should be used in a coordinated fashion.
Optimal coordination requires both policies to be passive
in the sense both work towards reducing the government debt to GDP ratio
The government restrains the FD and improves the supply side, while monetary policy reduces the cost of government borrowing
When both polices are passive multiple paths are possible
Coordination will be able to select the one with the highest growth and lowest inflation.
Whether policy needs to tighten or become
accommodative, a better balance of power will improve coordination
Possible alternatives to achieve this, and work towards a structure with balance, flexibility, adaptation to context, and constrained
discretion, are discussed below.
If factors that reduce costs can be quantified these could be discussed, and coordinated strategies worked
out in structured junior level meetings that could provide inputs to senior policy making meetings.
Strict inflation targeting encourages a
narrow view that ignores the interactions between monetary policy rates, financial regulation, and cost of government borrowing
The latter rose sharply partly because of hawkish monetary policy communication and regulatory reduction of the held to maturity (HTM)
category, just when rising rates imposed capital losses
analysts, academics and other government agencies, thus creating valuable competitive improvement.
Democratic pressures may force a
government to bend the fiscal rules and overspend
In a FIT and FRBM framework delegation to a pro-growth RBI governor and a conservative finance minister is likely to lead to optimal
The first will not implement FIT too strictly
The second, in order to resist populist pressures, will have to pay attention to composition of expenditure and to supply side
Accountability can be increased by instituting formal reporting to Parliament
Parameters can be set to evaluate if inflation targeting is being implemented flexibly
In the early years after independence, if RBI said no to the finance minister, the government would have to go to Parliament, which could
Now, under monetary dominance, if RBI says no to the finance minister, it should have to justify itself in Parliament.
Finally, the
inflation targeting agreement itself can be changed
Equal weight can be given to inflation and to growth if inflation is within the band
Since with low food inflation core CPI affects headline CPI not vice versa as earlier, easier to forecast core CPI could be made the
