Holistic management

Govt needed an ambitious fiscal road map

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) surprised most analysts last week by unanimously leaving the policy rate unchanged. The committee noted it had raised the policy rate by 250 basis points so far since May 2022, and that is still working through the system. The MPC also committed itself to remaining vigilant and not hesitating in taking further action if required in future meetings. The decision was surprising because the retail inflation rate was above the upper end of the tolerance band for the last two months. In fact, it was above 6 per cent in 12 of the last 14 months. Although the MPC foresees the inflation rate to average 5.2 per cent this fiscal year, it was reasonable to expect the central bank to be a little more conservative in its approach, given that it failed to attain the target last year as defined by the law.

The MPC, however, took the view that it had done enough for now and it made sense to wait and see how the policy rate action so far worked through the system. The given projections nonetheless suggest that inflation outcomes would remain significantly above the target of 4 per cent in the current year, and it remains to be seen when the rate will come closer to the target on a durable basis. While the central bank had been underestimating inflationary pressure for quite some time, the state of government finances made its job more complicated. A sustained higher fiscal deficit not only affects demand but also influences the central bank’s choices as the government’s debt manager. It is worth noting that the RBI had reduced the reverse repo rate disproportionately in the initial phase of the pandemic and flooded the system with liquidity.

Although these steps were arguably taken to support businesses, the biggest beneficiary was the government. The fiscal deficit at Union level, for instance, went up sharply to 9.2 per cent of gross domestic product (GDP) in 2020-21. While the fiscal deficit came down as the economy recovered, it remained elevated and was at 6.4 per cent of GDP in 2022-23. Accounting for states, the combined deficit was close to 10 per cent of GDP last fiscal year. Given the level of government borrowing and spending, it would always be difficult for the central bank to contain inflation along with achieving other objectives. It is likely that the RBI started late on inflation management to enable government borrowing at lower rates to the extent possible.

The Union government is aiming for a fiscal deficit of 5.9 per cent of GDP in 2023-24, and expects to bring it down to 4.5 per cent of GDP by 2025-26. Despite being a higher level for a medium-term deficit target, it would still be difficult to attain, partly because of the 2024 general elections. The government clearly needed a more ambitious fiscal consolidation road map and could have done more in terms of consolidation in recovery years. Macroeconomic management needs a holistic approach. Policy choices in one area can affect outcomes in others. A sustained higher fiscal deficit and borrowing can not only affect inflation outcomes but also undermine medium-term growth prospects by crowding out private investment.