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Last Updated : May 22, 2019 12:05 PM IST | Source: Moneycontrol.com

Policy Point | Why RBI will closely watch the election results

If exit polls are proved wrong and the NDA fails to get a majority, uncertainty on the economic front is bound to increase.

Rajesh Kumar @Rajesh_views

As officials start counting votes on Thursday, along with the rest of the country, members of the monetary policy committee (MPC) of the Reserve Bank of India (RBI) will be closely watching the incoming results which will decide the composition of the 17th Lok Sabha. The final tally will have a direct impact on the decisions of the rate-setting committee. The next policy review is due on June 6.

The return of the National Democratic Alliance (NDA) government with a clear majority, as predicted by most of the exit polls, will give confidence to the MPC that the new administration will adhere to the fiscal consolidation path. It has been reported that the Union government missed the revenue target by Rs 1 lakh crore in the last fiscal. This might require compression of expenditure in the current fiscal, which will have implications for growth, as revenue collection is unlikely to surprise on the upside. As reflected by lead indicators, economic activity is anyway slowing. Compression in government expenditure could further reduce economic growth.

However, this would also mean that core inflation, which has remained a concern for the MPC in recent times, would come down and open up space for further monetary easing. Remember, food inflation is showing signs of revival and is expected to go up from the present level. Food inflation in April was at 1.1 percent, compared with 0.3 percent in the previous month. A pick-up in food prices with sticky core inflation would make the MPC more cautious. Thankfully, core inflation has come down in recent months and is expected to fall further in the near term.

Close

However, if exit polls are proved wrong and the NDA fails to get a comfortable majority, uncertainty on the economic front is bound to increase. A comparatively large coalition with greater demand for resources will make the management of government finance more difficult, leading to a higher fiscal deficit. An elevated level of the budget deficit will not only be a risk to inflation projection but also threaten financial stability.

Members of the MPC are closely looking at the fiscal situation. Chetan Ghate in the last meeting, for instance, said: “I continue to view the elevated levels of the combined fiscal deficit and the on-going thrust towards competitive populism as jeopardizing the durability of inflation in the medium term. This should be carefully watched.”

Aside from the fiscal situation, the return of the NDA will also provide policy continuity. For instance, according to the amendment (2016) to the RBI Act, the inflation target is to be reviewed every five years. First such review is due in 2021. Although this calls for a wider debate, continuity in policy would mean that the government will not significantly change the target.

To be sure, the framework has worked well, and there are signs that it is helping to contain inflationary expectations. A significant upward revision in inflation target can affect the credibility of the framework. It is important for India to sustain low and stable inflation as it would help maintain financial stability and higher growth.

In the near term, the new government’s commitment to fiscal discipline will keep hopes of further monetary easing alive. A risk to fiscal targets would take this option off the table. In fact, even if the RBI reduces rates, higher borrowing by the government would further impede policy transmission and make it ineffective.

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First Published on May 22, 2019 12:05 pm
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