The fiscal-monetary tango

The past two years have seen the largest coordinated global fiscal-monetary stimulus since World War II. The early and aggressive policy response has clearly mitigated the economic impact. The global output gap took 36 quarters to close after the 2008 crisis. Remarkably, this time it’s on course to close in just 14 quarters, albeit with large regional variations. But injecting stimulus is the easy part. The challenge is in calibrating the withdrawal. Car accidents rarely occur during acceleration; instead it’s the inability to brake in time.

The Fed is finding out the hard way. A gargantuan US stimulus has kept aggregate demand elevated even as disrupted global supply chains are taking time to unwind. But the real supply-side challenge for the Fed will lie elsewhere: labour markets. The US is still almost four million jobs shy of pre-pandemic levels. Yet, the unemployment rate has plummeted from 7 to 4 per cent in a year because labour force participation has remained so depressed. A myriad of pandemic-induced behavioural changes may explain that, but the upshot is a very tight labour market with wages growing at 5 per cent. This has triggered a hawkish pivot from the Fed, with markets now expecting four rate hikes and balance sheet tightening this year. But markets still remain too sanguine that policy rates won’t need to rise to anywhere near “neutral”. There lies the risk. The more the labour market or inflation surprises, the more yields will need to reprice and the greater the reverberations felt around the world.Unlike 2013, the concern is not of a Taper Tantrum. Instead, the worry is that the spillover from US rates drives a premature tightening of monetary conditions in many emerging markets that can ill-afford it, given their more patchy and incomplete recoveries from the pandemic.   

This will have implications for India, too. Both fiscal and monetary policy have correctly remained very accommodative and complemented each other during the pandemic. Public sector borrowing requirements remain close to 11 per cent of GDP and real policy rates still remain meaningfully negative. Despite record government borrowings, therefore, real 10-year bond yields are much lower than before the pandemic. 

But by the third year of the pandemic, policymakers will have to become more selective, cognisant of both tightening global financial conditions and the domestic backdrop. Headline consumer price index (CPI) has averaged almost 6 per cent the last two years and with inflation expectations tending to be adaptive, both business and household expectations have hardened over the last year, making the policy trade-off between slack and prices more unfavourable. More recently, external balances have begun to widen. The current account deficit (CAD), which averaged just 1.4 per cent of GDP since the Taper Tantrum, is on course to averaging 3 per cent of GDP in the second half of 2021-22, underpinned by higher oil prices (a negative terms-of-trade shock) and gold imports. To be sure, the CAD is expected to mean-revert but to the 2 per cent of GDP handle, if crude prices stay around $80 a barrel. This may not pose an immediate threat but will warrant policymakers keeping one eye on.

Illustration: Ajay Mohanty

These dynamics will create some constraints on domestic policy. None of this is to suggest fiscal and monetary policy must aggressively normalise in conjunction. Absolutely not. With the economy still 6-7 per cent below its pre-pandemic path and activity still uneven — across sectors, income groups and factors of production — the recovery will need to be nurtured and nourished.  Supporting activity and job creation — but being mindful of inflation, the current account and debt dynamics — will, therefore, entail a deft policy balancing act in 2022.

What this will necessitate is for monetary and fiscal policy to slowly evolve from being complementary to being substitutive. If one arm of policy remains very accommodative, the other must begin to normalise commensurately. But which should it be? Asset markets will clamour for loose monetary and tighter fiscal. The former will prop up equity markets (through a low discount rate), while the latter will buoy bond markets (through lower borrowing). 

But, in fact, the nature of the recovery demands the opposite. Despite very accommodative monetary conditions, credit growth, while slowly picking up in nominal terms, remains muted in real terms, which is unsurprising because monetary policy tends to lose efficacy during periods of high uncertainty. Wary about economic scarring, the financial system still remains relatively risk averse and households remain cautious about borrowing to consume.

This is precisely where fiscal policy has to break the logjam. With manufacturing utilisation rates in the 60s, private investment will take time to recover. Instead, public investment — in infrastructure, health and education — will have to drive the near-term recovery. The Centre impressively increased its capex spending from 1.6 to 2.2 per cent of GDP in the pandemic year. This emphasis, however, will need to continue. Capex is undershooting budgeted run-rates for the Centre and states this year and it will be crucial to re-accelerate those rates. Capex apart, fiscal policy is more suited to respond to an uneven recovery through its ability to provide more targeted support and automatic stabilisers (free food grains, Mahatma Gandhi National Rural Employment Guarantee Act or MGNREGA).

So what can the upcoming Budget do? Ideally, consolidate by just 0.5 per cent of GDP and not more, but situate this gradual consolidation amidst a credible medium-term framework. The fiscal could experience subsidy savings of almost 1 per cent of GDP next year as some of the extra-support announced after the second wave rolls–off. The Budget can use half of that to consolidate the deficit and the remaining to bolster spending (from capex to ensuring MGNREGA is fully funded) so as to support demand and job creation.   

But precisely because fiscal is normalising slowly, monetary policy must avoid fiscal dominance and start normalising, albeit in a calibrated and non-disruptive manner, to preserve macro stability. Nudging up real rates, for example, should also reduce gold demand and help the current account.

One immediate reaction to a relatively-looser-fiscal and relatively-tighter-monetary mix will be that bond yields will rise. If, for the sake of argument, yields go up 50 basis points in the process, that would, in my view, be a small price to pay to create much-needed fiscal space for high-multiplier investments in infrastructure, health and education. Moreover, it’s the certainty of demand for a few years (with which government spending can help) that will drive the next private investment cycle rather than 50-100 bps of interest rate moves, as the last 12 months of low rates have revealed.

The same goes for debt dynamics. Borrowing costs rising by 50 bps do not imperil medium-term debt sustainability, but if the fiscal is tightened too quickly, and steady-state nominal GDP settles below 10 per cent, debt dynamics will get destabilised.

The need to support the recovery, while being mindful of macroeconomic stability, is the central challenge for 2022. This would argue for fiscal and monetary policy to slowly evolve from being complementary to substitutive. 

The pandemic years called for policy reinforcement. The post-pandemic aftermath will call for policy prioritisation.

The writer is Chief India Economist at J P Morgan. All views are personal