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Mainstream, VOL L, No 8, February 11, 2012

Mid-Term Monetary Policy Review: The Way Ahead

Tuesday 14 February 2012, by Anshuman Gupta


In a sovereign state, the economy is regulated largely by the monetary and fiscal policies. Their roles increase in significance even more in a market economy, where there is no scope for direct controls. There is always a need for the judicious coordination of both the policies for achieving the desired optimal results. However, in reality this is not always the case. More often than not the political economy decides which tool should be used more in proportion and it is invariably the monetary policy tool which is used more frequently at the cost of fiscal policy, especially at the time of containing inflation. Nothing can better explain this reality than the recent developments in the Indian economy.

The RBI has increased the basic policy rates 13 times during the last one-and-a-half year in a bid to control the inflation rate, though it became quite obvious that the reason for the high inflation was not only excessive demand in the economy but also the structural problems specially in the agriculture sector languishing for a long time owing to no or inadequate reforms in this sector. The RBI tried to cover up the policy paralysis and reluctance to prune fiscal deficit on the part of the government through monetary measures. This injudicious mixture of monetary and fiscal policies has rather increased the problems in the economy instead of alleviating them. It has hurt the growth rate in the economy, which has been revised down-wardly many a time. It is estimated to be below seven per cent this fiscal year and would be around 6.5 per cent next year. All the main indicators like fiscal deficit, current account deficit, debt ratio, etc. are not favourable either.
Because of this injudicious mixture of both monetary and fiscal policies, the Indian economy has been pushed to a position where it would not be able to withstand the pressure of another economic crisis looming large in Europe and the US. India was able to weather the last recession of 2008 on account of enough space at the fiscal and monetary fronts at that point of time to initiate the required counter-cyclical measures. It initiated stimulus measures at the fiscal and monetary fronts. The interest rates were reduced and many entitlement schemes, which were already there, were pursued more vigorously. These were able to make up for the reduced growth rate at the external front owing to the recession in the US and Europe in the wake of the sub-prime crisis. However, this time this space would not be there for India at the fiscal front if another recession strikes the world economy in the aftermath of the European crisis.

In fact, last year was supposed to be the year of consolidation at the fiscal front. This was well planned in the Budget (2011-12). However, the political compulsions did not allow the government to do enough on this front. The fiscal deficit was targeted at 4.2 per cent of the GDP for the current fiscal by mainly well-targeting the subsidies. However, there would be slippage by a big margin. A conservative estimate puts it at above six per cent of the GDP. This is the combined result of low growth rate and burgeoning deficit as a result of many social schemes and inadequate reforms at the subsidy front. As a result of failure by the government to consolidate at the fiscal front, the Indian economy has now been rendered vulnerable if a major recession strikes the world economy.

The third-quarter monetary policy review meeting of the RBI has brought the much-awaited respite for the Indian industry. Though it has not reduced the policy rates, it has scaled down the CRR by 0.5 per cent and signalled the reduction in policy rates in the near future.

U-Turn in Monetary Policy Stance

IN the last mid-term monetary policy review meeting, the RBI has signalled the beginning of a U-turn in its stance by reducing the CRR by 0.5 per cent and indicating the reduction in policy rates in the near future. Though late, this would create a feel-good factor in the economy besides infusing on additional Rs 32000 crore worth of liquidity in the system. Though in the short run there might not be any change in the prime lending rates (PLR) by the banks, the increased liquidity would help reduce the spread above the PLR.

In the medium and long runs, this change of monetary stance by the RBI, from a hawkish to a dovish one, would make a lot of difference in the expectation of people, and that would help propel the growth rates not only in the medium and long runs but also in the short run. In fact, the behaviour of economic agents, including firms, consumers, etc., are decided in the modern economy not only by the current nominal and real variables (like nominal interest rates, real interest rates, inflation rates, etc.), but also by the expected nominal and real variables in the future.

The expansionary monetary policy would only affect the nominal interest rates in the short run. However, spending in the economy would depend on the current real interest rates and expected future real interest rates. The effect on the current and expected future real interest rates depends on two factors:

• whether the increase in money supply is resulting in the economic agents in the economy revising their expectations of the future nominal interest rates, and

• whether the increase in money supply leads the economic agents to revise their expectations of the current and future inflation rates.

If, for example, the economic agents expect that the future nominal interest rates would be further lowered down and the inflation rate would be the same or decrease to less than the nominal interest rates so that the net future real interest rates in the economy would be lesser than current real interest rates, it would have a positive impact on spending not only in the medium- and long-terms but even in the short run as well. Similarly, if the inflation rate is expected to increase in the future as a result of increase in money supply so that the expected real interest rates decrease by more than the expected future nominal interest rates, it would also have a positive impact on spending in the short, medium and long runs.
Now that the RBI has taken the dovish stance and this has been indicated properly by it in its statement, it would help the economic agents reduce their expectations about the future nominal interest rates in the economy and anticipate increased inflation in the medium- and long-terms. The combined effect of these two expectations of the economic agents would be the expectation of the reduced future real interest rates. It should have a positive impact on the short-term production also.

This implies that the impact of the current monetary policy stance would be decided by not only the current nominal and real interest rates and the current level of production but also the expected future nominal and real interest rates and the expected future level of production. When the expected real and nominal interest rates are down and the expected level of income is higher in the economy, it would even increase the income level in the short run as well.

In fact now that the RBI has made a good start, a lot would depend on how it capitalises on it in the future by its actions so as to help the economic agents make expectations about future variables in the desired direction. This would not only depend on the RBI itself. It would also be dependant to a great deal on the government (especially the Finance Ministry) to make the economic agents believe in the desired direction. The Finance Ministry would have to indicate this through the Budget by proposing realistic and drastic actions for consolidating its finances. Since the government has lost its credibility in the last Budget by making calculations on the basis of unrealistic assumptions, it would have to work harder to regain its credibility.

The Role of Budget

NOW the role of the Budget (2012-13) would be crucial to complete the work initiated by the RBI. It would have to come out of the image of an inactive government perpetuating policy paralysis in the economy and take some bold steps to put its finances on a sound footing. The credible Budget proposals and plans to consolidate at the fiscal front for the current year and future would help the economic agents make favourable expectations about the economic variables for the future which would, in turn, help propel the economic growth even in the short run.

The consolidation of finances can be brought about either by increasing the tax rates or by reducing the expenditures. Increasing the tax rates is a good idea not for the short-term nor for the medium- and long-terms. It will leave less disposable income for the households and less investible income for the firms, which would adversely affect the growth in the short run. The world experiences show that it would not be conducive to forming positive expectations in the long run either. For instance, the same route was applied in Ireland in 1981 for consolidating the fiscal position. However, it left an adverse impact on the growth not only in the short run but also in the medium and long runs. It reduced the investment rate, increased the unemployment rate and increased the savings rate of the house-holds, which was a sign of reduced expectation of the economic agents about economic growth in future.

The second method of restoring the finances is by reducing expenditures. Though some expenditures cannot be reduced as a result of their significance for the economy, some others might be attempted to streamline them. For example, subsidies can be reduced by doing away with the universal element from them and making them well-targeted. The fuel products’ prices, like diesel and LPG, should be fully deregulated. Diesel prices, at least, can be made market-determined for the personal vehicles. Even the LPG used in homes should be charged the market price.

The social entitlement schemes, like the MGNREGA, the newly proposed Right to Food Act, etc., should be made more focused and the beneficiaries should be properly defined so as to cover the needy sections only rather than pursuing the unmindful generous approach to cover as many people as possible for populist considerations.

The world experiences show that a long-term plan for improving the finances with less cuts in the short run and more cuts in the long run would bring the most desirable results. Less cuts would have less unfavourable impact in the short run and improved expectation about the future condition of the economy would motivate the economic agents to increase their spending in the short run as well. As a result of improved economic activities, the government would be able to have more tax collections which, in turn, would help in further reducing the fiscal deficit.

Dr Anshuman Gupta is the Head, Economics and IB Department, University of Petroleum and Energy Studies, Dehradun.

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