This year, there will be a need for more borrowing by the government. The framework of inflation targeting will actually generate a balance sheet expansion and government bond purchases by the Reserve Bank of India. In other words, the RBI will need to print money.
If India is not being able to find an easy exit strategy from the lockdown, the economy may have to operate at subsistence level for longer. The government will need to generously distribute food grains, and do direct cash transfers to the poor who have no savings to survive. Under those circumstances, monetising the deficit, or an inflation tax, would be the mechanism through which resource transfer happens.
Printing money can help move resources from those with some existing savings to those with no existing savings. Households with no wealth get a claim over goods and services produced in the economy. Eventually, it is expected that prices will rise. The claims of the middle classes, pensioners, and households who have saved in bank accounts in previous years will be lower in real terms. Inflation is a way to tax those with savings. The real value of their savings goes down.
Monetising the deficit
In a long lockdown, in the absence of production, tax collections will collapse. Wealth or inheritance taxes usually yield little revenue, even if there was time to collect them. The fiscal deficit would rise. Normally, government borrows private savings. Under a lockdown, as incomes fall, private savings will fall.
How will the deficit be financed? The government could borrow from the RBI. ‘Monetisation of the deficit’, as it is called in economic jargon, is what happens when government borrows from the central bank. In the past, India called this “deficit financing”. It was stopped in the 1990s because printing money caused high and persistent inflation. It is a last resort in financing the deficit. It risks governments getting addicted to it, and using it in normal times to finance deficits.
In the past, many central banks that have targeted inflation have engaged in quantitative easing when interest rates have hit the ‘zero lower bound’, or, when it has no longer been possible for the monetary policy committee to cut rates further, as they are already at zero.
We saw that happen in advanced economies after the global financial crisis.
When monetary policy is used to target inflation, it focuses on the demand-side aspects of inflation. It looks at whether there is excessive demand in the economy putting pressure on prices to rise. It compares projected levels of demand to the potential of the economy to supply.
By increasing interest rates, monetary policy encourages people and businesses to spend less. By anchoring expectations about inflation, it helps curb inflation through wage price spirals. By cutting interest rates, it helps banks to lend more, and people to spend more, pushing up demand and prices, and helping reach the inflation target from below.
How would monetary policy function in a lockdown?
Monetary policy has never had to function in times when both demand and supply have completely collapsed, when production is at a near-standstill, when consumers cannot spend because of physical constraints, or are not being allowed to step out to buy goods and services. The present circumstances are completely new terrain for monetary policy.
If the lockdown were for a few days, perhaps the analysis may be as under ‘business as usual’. But what if restrictions remain in place till a vaccine is found?
For a vaccine to be mass produced and to reach every person in India may take a year or more. Under such circumstances, if the country decides to continue the lockdown, our understanding of economics, markets and of monetary policy will be in completely unchartered territory.
At one extreme is an optimistic scenario of opening up the economy on 3 May. On the other extreme, there could be a severe lockdown for a year. The reality may be something in between. Some districts and activities may open and shut depending on the spread of the coronavirus.
In the extreme scenario of waiting for a vaccine, what happens if the government locks down the economy for 2020-21? The first month of this financial year, with little economic activity, the collapse of consumption, investment and exports, will lead to a severe contraction in production.
When demand is as low as it is under a lockdown, the risk of demand-led inflation is zero. There could be supply shortages of essential goods, but these would be in specific products, and eyeing opportunities for profits, producers could step in quickly to seize the opportunity. This involves a change in relative prices. We have seen that for masks and sanitisers, whose prices rose and then fell. Monetary policy has no role to play.
Under conditions of overall low demand, India would be producing far below potential capacity; its framework of inflation targeting would require very low interest rates, and even quantitative easing. The framework of inflation targeting would involve cutting interest rates to achieve very low or even zero interest rates in the economy.
Inflation targeting literature, especially after the global financial crisis, has adequate discussion and international experience of what to do in a situation where normal cutting of the repo rate does not help reduce interest rates across the economy. The central bank can buy government securities against which it issues money.
An analysis of the pros and cons of various policy options should be carefully considered and discussed. There is no need to undermine the credibility of our macroeconomic framework, of which the 2016 amendment to the RBI Act, giving a way to anchor the rupee through an inflation target, is a critical element.
The author is an economist and a professor at the National Institute of Public Finance and Policy. Views are personal.
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