The global financial markets in terms of liquidity, capital base of banks and appetite for taking risk have shown significant progress in recent months. Against the backdrop of all the talk of revival, decision-makers and commentators have started to deploy their mental bandwidth towards the timing and scope for reversing course of the super-steroid expansionary policy introduced in the aftermath of the Great Financial Crisis of 2008.
While some may consider talk of a macro policy retraction as premature, there is merit in examining the subject. Firstly, policymakers are uncomfortable with the unconventional tools that have been deployed (for example, resorting to the printing presses of the central bank to fund deficits; relaxation of lending norms to help sectors whose problems were unrelated to the crisis but were bailed out in the “anything goes” frenzy post-September 2008). Secondly, like good law enforcement officers who worry about the next crime wave that will almost inevitably rear its head even as the current one is licked, central banks have to think ahead because, well, that is their dharma. Thirdly, the pullback from the Great Depression Mark II seems to be for real (at least in terms of the rate of change in output and unemployment measures). Lastly, tensions are intensifying as a consequence of the global easing, specifically, “green saplings” of asset bubbles in the commodities and emerging markets spheres may have taken root.
While there is some general discussion about when to reverse course, thinking through meeting the challenge in India could move forward by proposing “signposts” that take into account the balance-of-risks regarding macroeconomic stability. The motivation is to coalesce a consensus around fiscal and monetary aspects that may guide the turnaround in policies.
The “signposts” could have the following characteristics: First, they should be transparent, and concomitantly should be based on observable “outcomes” (preferably high-frequency data with relatively short reporting lags). Second, there should be a close mapping between the macro variables that trigger the course reversal and policy choices. Third, policies should be feasible; in other words, those which may be given a chance to work given political reality.
After frittering away the gains from an exceptional five-year growth period, the extant liberal fiscal stance (open-ended subsidies, funding loss-making PSUs and tax giveaways), validated by the backwash from the international financial crisis, has engendered justifiable concern that bringing back normality to the Indian fiscal situation will be arduous, and may not even be possible over the medium term. Solvency, loosely speaking in terms of an (interminable) exploding debt-GDP ratio, is not an immediate concern given forecasts of nominal GDP growth, and yields on government bonds. On the other hand, the crowding out of private investment (through the interest rate channel) is agitating the central bank and the commercial bankers (both are in the operational “hub” of this area, and what they say matters). In this context, a large-scale resort to borrowing abroad by the private sector can store up problems beyond official debt servicing. Furthermore, with the government’s contribution to the savings-GDP ratio now firmly in reverse gear, sustaining the high economy-wide savings rate achieved in recent years will not be possible.
The timing of fiscal consolidation could be mapped to an increase in the tax/GDP ratio. An up-tick in the ratio is usually suggestive that (broad-based) economic recovery is underway, and thus it may be feasible to pursue a declining fiscal deficit trajectory. The increase in revenues should be “ring-fenced” (in a manner of speaking) for bringing down the deficit, and not spent away. Why choose a revenue-based signpost? The suggestion proffered here is a passive strategy, not because it is the optimal one, but because the prospect for a sustained cut in expenditure in the present political milieu seems to be limited (there is some election every year); therefore, keeping a lid on spending will be difficult enough. Regrettably, almost all major categories of expenditure have acquired “sacred cow” status; commitments from Pay Commission awards are yet to percolate through completely; and it is only a matter of time before the income transfers to the poor are expanded in scope and become inflation-linked.
Turning to monetary policy, the relevant signpost is inflation; it is instructive that recently some central banks have downgraded growth forecasts and upped inflation expectations. Evidence that inflation is likely to exceed a threshold on a sustained basis should bring about the calibrated reversal in monetary policy in India comprising of policy rates and reserve ratios. By way of illustration, a “trigger” at, say, the 3 per cent level (measured by the wholesale price index) could help to ensure that steady-state inflation does not exceed the comfort zone of about 4-5 per cent since the monetary transmission mechanism works with lags. (Sensible people can differ on the reasonableness of the inflation threshold, but few would argue that domestic inflation is not influenced by monetary policy.) The turning point for the accelerating upswing in prices has to be identified, and the government may have to be convinced that the time for monetary retrenchment had arrived. The assertion that at some point inflation will inevitably exceed the upper level of the comfort zone, and so tightening should start today, may not be acceptable. The task for the central bank in this regard may get more onerous, especially if financing pressures from the fiscal side don’t subside soon.
Finally, it is unsettling that we have yet to conclusively agree on a single (consistent) national measure of inflation (most countries in the world have had one for decades); the difficulty for economic agents comes about when diverse decision-makers deploy indices that best justify their respective flavour-of-the-day arguments for policy action, or inaction. But this obfuscation is not costless since credibility is compromised, which in turn means that more fire power has to be deployed (than would otherwise be the case) to shape price expectations.
The global financial markets in terms of liquidity, capital base of banks and appetite for taking risk have shown significant progress in recent months. Against the backdrop of all the talk of revival, decision-makers and commentators have started to deploy their mental bandwidth towards the timing and scope for reversing course of the super-steroid expansionary policy introduced in the aftermath of the Great Financial Crisis of 2008.
While some may consider talk of a macro policy retraction as premature, there is merit in examining the subject. Firstly, policymakers are uncomfortable with the unconventional tools that have been deployed (for example, resorting to the printing presses of the central bank to fund deficits; relaxation of lending norms to help sectors whose problems were unrelated to the crisis but were bailed out in the “anything goes” frenzy post-September 2008). Secondly, like good law enforcement officers who worry about the next crime wave that will almost inevitably rear its head even as the current one is licked, central banks have to think ahead because, well, that is their dharma. Thirdly, the pullback from the Great Depression Mark II seems to be for real (at least in terms of the rate of change in output and unemployment measures). Lastly, tensions are intensifying as a consequence of the global easing, specifically, “green saplings” of asset bubbles in the commodities and emerging markets spheres may have taken root.
While there is some general discussion about when to reverse course, thinking through meeting the challenge in India could move forward by proposing “signposts” that take into account the balance-of-risks regarding macroeconomic stability. The motivation is to coalesce a consensus around fiscal and monetary aspects that may guide the turnaround in policies.
The “signposts” could have the following characteristics: First, they should be transparent, and concomitantly should be based on observable “outcomes” (preferably high-frequency data with relatively short reporting lags). Second, there should be a close mapping between the macro variables that trigger the course reversal and policy choices. Third, policies should be feasible; in other words, those which may be given a chance to work given political reality.
After frittering away the gains from an exceptional five-year growth period, the extant liberal fiscal stance (open-ended subsidies, funding loss-making PSUs and tax giveaways), validated by the backwash from the international financial crisis, has engendered justifiable concern that bringing back normality to the Indian fiscal situation will be arduous, and may not even be possible over the medium term. Solvency, loosely speaking in terms of an (interminable) exploding debt-GDP ratio, is not an immediate concern given forecasts of nominal GDP growth, and yields on government bonds. On the other hand, the crowding out of private investment (through the interest rate channel) is agitating the central bank and the commercial bankers (both are in the operational “hub” of this area, and what they say matters). In this context, a large-scale resort to borrowing abroad by the private sector can store up problems beyond official debt servicing. Furthermore, with the government’s contribution to the savings-GDP ratio now firmly in reverse gear, sustaining the high economy-wide savings rate achieved in recent years will not be possible.
The timing of fiscal consolidation could be mapped to an increase in the tax/GDP ratio. An up-tick in the ratio is usually suggestive that (broad-based) economic recovery is underway, and thus it may be feasible to pursue a declining fiscal deficit trajectory. The increase in revenues should be “ring-fenced” (in a manner of speaking) for bringing down the deficit, and not spent away. Why choose a revenue-based signpost? The suggestion proffered here is a passive strategy, not because it is the optimal one, but because the prospect for a sustained cut in expenditure in the present political milieu seems to be limited (there is some election every year); therefore, keeping a lid on spending will be difficult enough. Regrettably, almost all major categories of expenditure have acquired “sacred cow” status; commitments from Pay Commission awards are yet to percolate through completely; and it is only a matter of time before the income transfers to the poor are expanded in scope and become inflation-linked.
Turning to monetary policy, the relevant signpost is inflation; it is instructive that recently some central banks have downgraded growth forecasts and upped inflation expectations. Evidence that inflation is likely to exceed a threshold on a sustained basis should bring about the calibrated reversal in monetary policy in India comprising of policy rates and reserve ratios. By way of illustration, a “trigger” at, say, the 3 per cent level (measured by the wholesale price index) could help to ensure that steady-state inflation does not exceed the comfort zone of about 4-5 per cent since the monetary transmission mechanism works with lags. (Sensible people can differ on the reasonableness of the inflation threshold, but few would argue that domestic inflation is not influenced by monetary policy.) The turning point for the accelerating upswing in prices has to be identified, and the government may have to be convinced that the time for monetary retrenchment had arrived. The assertion that at some point inflation will inevitably exceed the upper level of the comfort zone, and so tightening should start today, may not be acceptable. The task for the central bank in this regard may get more onerous, especially if financing pressures from the fiscal side don’t subside soon.
Finally, it is unsettling that we have yet to conclusively agree on a single (consistent) national measure of inflation (most countries in the world have had one for decades); the difficulty for economic agents comes about when diverse decision-makers deploy indices that best justify their respective flavour-of-the-day arguments for policy action, or inaction. But this obfuscation is not costless since credibility is compromised, which in turn means that more fire power has to be deployed (than would otherwise be the case) to shape price expectations.
