One of the biggest challenges facing Finance Minister Nirmala Sitharaman when she stands up to present the Union Budget 2020-21 is how to improve investor confidence. She should avoid the temptation of trying to blame it all on monetary policy. In any case, cost is not the biggest constraint facing investors today; it is the uncertain policy environment.
On the one hand, the FM will be advised to provide a stable policy regime, while on the other, there will be demands for her to solve problems by making policy changes.
It seems like an impossible tight-rope walk to provide investors with greater policy certainty; give a boost to demand and public investment; and grapple with slowing tax revenues, shortfall in disinvestment targets and higher borrowing.
Temptation to give up framework
At present, the fiscal deficit is higher than envisaged and the fiscal space is limited. A number of commentators would advise Sitharaman to be fiscally prudent. One temptation may be to try to push more of the burden of expansionary policy to monetary policy. Since monetary policy is constrained by an inflation target, she may be tempted to give up the inflation targeting (IT) framework as some economists are suggesting. Would this solve the problem?
Giving up the IT framework would cause more policy uncertainty, and would be very unwise. First, note that the law only requires a review of the inflation rate, and not the framework as a whole, as many commentators seem to be assuming. It would have been highly irresponsible of lawmakers to envisage a review to the framework every five years. It takes many decades of low inflation to dampen inflationary expectations.
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If the country reviews the monetary policy framework every five years, it will have no nominal anchor. A nominal anchor, in the simplest sense, is what determines whether the price of a loaf of bread is Rs 30 or Rs 300, or that of a sandwich is Rs 60 or Rs 600. Relative prices of the loaf of bread to the sandwich may be such that the sandwich costs twice as much, but we need a ‘nominal anchor’ to ensure that that the loaf of bread does not cost Rs 30 one day, Rs 40 the next and Rs 50 the third.
India’s tryst with inflation targeting
Earlier, central banks used to try to keep money supply under control to ensure that prices don’t rise very rapidly, but with the introduction of new payment systems, it became difficult for central banks to control money supply, i.e. the quantity of money, so they moved to using the interest rate, i.e. the price of money, to achieve the same effect. How much should prices be allowed to rise was defined by the “inflation target”.
Alternative nominal anchors that can be chosen by India are (i) to target a nominal GDP, something that is debated but not tried and tested, and where there is no cross-country evidence on how it impacts inflation, or (ii) the nominal exchange rate.
In the past, many countries used to peg the nominal exchange rate, but as cross-border flows increased, this started impacting domestic credit conditions in undesirable ways. For example, when large capital inflows took place, as they did in India in the mid-2000s, and the RBI tried to prevent rupee appreciation, it purchased dollars in the forex market and a larger monetary base led to a sharp increase in liquidity and credit in the economy. This was inflationary, amplified the business cycle, and led to overheating in the economy.
Due to the pro-cyclical nature of exchange rate targeting, countries, including India that witnessed this in the 1990s and 2000s, moved to inflation targeting in 2016.
India adopted a flexible inflation targeting rate as a formal legal mandate of the RBI in March 2016. The preamble to the RBI Act, as well as relevant sections in the act, were amended to enable this change. One of these sections, 45ZA, states that the rate of inflation that is to be targeted needs to be reviewed every five years. “The central government shall, in consultation with the bank, determine the inflation target in terms of the consumer price index, once in every five years,” Section 45ZA states.
The present target is 4 per cent annual inflation with a band of plus/minus 2 per cent. This means that inflation may be within a band of 2 to 6 per cent. In March 2021, the central government, along with the RBI, is required to review the target. It may review the four per cent target, but not the framework.
Avoid burdening monetary policy
One of the most serious challenges facing the Modi government in 2014 was how to restore macroeconomic stability. The second half of 2013 had witnessed a falling rupee after the ‘taper talk’ by US Fed chairman Ben Bernanke, when India was seen as a fragile economy or one of the fragile five economies. Trying to defend the rupee under these conditions created immense liquidity shortages in the economy. This further emphasised the need to move away from exchange rate pegging.
On 1 February, Finance Minister Sitharaman should avoid any temptation to push the burden on monetary policy and instead work on improving monetary policy transmission by reforms in the banking sector and bond markets.
The author is an economist and a professor at the National Institute of Public Finance and Policy. Views are personal.
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