We are now facing a situation where we face inflation outside our confortable bracket of 2-6% on one side and on the other hand the supply side of the country is unable to meet the required demand on account of the Covid pandemic. The headline inflation has breached the required range, from 2 to 6 per cent consumer price index (CPI)-based inflation, in seven of the last eight months. Ajay Shah says this in the Business Standard:
Monetary policy impacts the economy with a lag of about 12 to 18 months. Therefore, a simple reading of the inflation crisis from December 2019 to July 2020 would suggest that the policy rate was too low in the period from June to December 2018, that the MPC in those months failed to anticipate this surge in inflation in the future. The policy rate peaked at 7 per cent in September 2018 and then the rate cuts began: Perhaps this timing and the scale of the cuts were excessive.
The monetary policy committee (MPC) of the RBI is unable to increase interest rates to control inflation, as this would suck money out of the system and further adversely affect production dynamics. The lockdown has had an adverse impact upon supply chains causing shortages of many goods. Hence prices have risen to clear the imbalance between supply and demand. The easing of the lockdown that began from April 18 is now well underway and the supply situation, which eased in August, will ease further. By September, headline inflation is likely to be lower and MPC cannot act on such transient situations.
The MPC is also unable to cut rates as this would pump more money into the market thereby further increasing inflation. Hence the monetary policy is in effective in managing the economic situation and spur growth at this point and we need to look at other instruments available to enhance growth and supply.
The bottlenecks lie in financial policy. When banks are stressed, they are loath to borrow at low rates and lend into the economy. The growth of bank credit peaked (YoY) in December 2018, at about 15 per cent and has declined to near zero since then. With better banking regulation, banks would not have been in the difficult state they are in terms of increasing NPAs and would have been in a better frame of mind to lend.
Similarly, the bond market is picking up offerings from a few good corporates and others have been cut off from the bond market. Even though the de facto policy rate is at 3.23 per cent, there are very few takers for corporate bonds even with their higher returns. With better regulation a good bond market would have helped push cash into the economy to spur growth.
We require big-ticket institutional reform in financial regulation to strengthen Banks and NBFCs and the learning over the past few years would better inform this effort.
Fiscal policy is the use of government spending, taxation and transfer payments to influence aggregate demand. The Government of India announced a fiscal stimulus package to support the economy. The Committee for a responsible federal Budget has quoted IMF research which says that response packages that included both revenue and spending reforms lead to faster growth in 60 percent of the cases examined and were also more likely to spur growth than ones that changed only one or the other.
The IMF report notes that high public debt hampers economic growth by "increasing uncertainty over future taxation, crowding out private investment, and weakening a country's resilience to shocks"; therefore, deficit reduction should help to alleviate these effects.
In addition, the authors find that budget-neutral reforms – for example, lowering tax rates while broadening the tax base – can also help to promote economic growth by improving incentives to work, encouraging investment, increasing human capital, and encouraging innovation. The authors' preferred methods for offsetting deficit-increasing measures include eliminating tax exemptions and preferential tax rates for certain types of income, shifting from direct taxes to indirect and property taxes, introducing environmental taxes to price negative externalities, and better targeting spending programs to those with the greatest need.
The study also found that the type of reform enacted affected the probability that it would accelerate growth. In particular, reforms to personal income taxes, health spending, and social security contributions were most likely to lead to growth acceleration while reforms to property taxes or capital spending had a low probability of doing so. In addition, the inclusion of fiscal measures in a package with other complementary reforms (such as deregulation) and social dialogue with relevant stakeholders was found to increase the likelihood of success.
Fiscal stimulus packages will fail to deliver desired results if not designed properly and if attention is not paid to necessary additional reform measures required to be taken. Growth seems to be possible only when monetary policy and fiscal policy measures are taken.
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