A ferocious bout of coronavirus has worsened the economic environment since the April 5 monetary policy review. From then to now, daily cases have paced strong, exceeding 200,000 on April 15.
The virus’ wildfire spread displays no sign of abatement, surpassing the previous wave by a mile and more. In a further adverse twist, the slow-paced vaccination drive stumbled against supply constraints due to poor planning and lack of foresight. The obvious casualty is economic recovery and normalisation.
With another round of localised but widespread restrictions, lockdowns and other curbs gathering force each day, there’s no doubt these set back the strengthening recovery. The worst part is the second successive adverse shock to growth in a year squeezes monetary and fiscal policies into a narrower space, weakening the capacity for macroeconomic responses.
By now it is well-observed that second waves have been checked at lower output costs, e.g. as established for Europe. The same, however, does not extend to policies. This is truer for India than most other countries because of weak growth and deteriorated fiscal position even at the pandemic’s arrival one year ago. This limited fiscal support, the sparseness of which affected recovery and aggravated the loss of output.
The IMF’s recent global assessment shows the faster recoveries are attributable to quick, substantial fiscal responses that also limited output losses (e.g. the United States, the United Kingdom, Europe, Japan among others); countries without fiscal buffers or affordable financing access (mostly developing ones) have lagged. The IMF estimates the gap in India’s level of output in 2024 (assuming no COVID-19) is a sizeable 8 percent, 5 percentage points more than for the world as whole (3 percent) and double the emerging market estimation (EME) of 4 percent. This shows the scarring caused by the pandemic and loss of ground that India has to recover.
With another, worse infection wave throwing the nascent recovery off-track, the challenge is now greater. The faltering growth, increased inflation pressures, and a transformed global economic outlook where the US’ fiscal stimulation is the main powering impulse have fresh and constraining implications for monetary and fiscal policies. What are these?
Less than a fortnight ago, the monetary policy committee retained the policy rate and growth projection, upgraded inflation forecasts, and changed forward guidance to remain accommodative until recovery prospects are ‘well secured’. To lower the domestic risk-free rate and support government borrowings, the Reserve Bank of India also committed to quarterly bond purchases of Rs 1 trillion over usual open market operations. At the time, the second wave wasn’t a wildfire, the IMF’s views were awaited, but market impacts of the US’ fiscal stimulation apparent.
Recent data indicates that industrial output growth — a second successive contraction in February with index slipping to October 2020 level — may have run out of steam this year; possibly the pent-up demand peaked. It is noteworthy the PMI peaked in January, moderating thereafter. March retail inflation rose higher than anticipated (5.52 percent), mainly because of supply bottlenecks and cost-side forces; core inflation moderated slightly. Wholesale price growth jumped 322 basis points (7.39 percent) above the February print. World output is now predicted to grow 6 percent this year by the IMF, a respective 50 and 80 basis points above January and October forecasts.
Do the evolving configurations pressurise monetary policy?
An unqualified answer is elusive, considering the sharp, rapid slide in economic conditions caused by COVID-19’s resurgence. However, identifying markers are possible.
One, the source of inflation matters: here, the size of negative domestic demand — now enlarged with significant uncertainty — overweighs supply shocks, especially in the services sector. Its persistence and aggravation risks from further restrictions could be concerning, but bottlenecks are resolvable. How the producer-to-retail core inflation transmission evolves will be in the spotlight with expectation the outsized output gap can help ride out pandemic inflation.
Two, rupee depreciation is a multiplier for rising global commodities’ inflation. However, devaluation is not merely inflationary, but can be expansionary, e.g. enable better exploitation of US demand spillovers, boost exports and domestic income. The RBI also doesn’t have much choice on competitiveness grounds as a strengthening dollar affects all EMEs, some of who have already raised interest rates.
Finally, the possible repercussions if global financial conditions suddenly tighten, pushing up risk premia with reversal of capital due to unexpected change or intent thereof in US’ monetary policy. Although such changes tend to have important ramifications for financial conditions, this reality is presently distant. It may not be an important driver of domestic monetary policy rate for some time.
The emerging choice for the RBI may be this: barring a nasty inflation surprise, let domestic economic conditions govern monetary policy with flexible exchange rate response to evolving external monetary and financial conditions. The central bank will have to see if the cost of capital is a bigger constraint.
That said, monetary policy faces intensified pressure upon its fiscal cooperation role. Tax revenues will be eroded; additional expenditure requirements for health, vaccine supply expansion, social protection, etc. will increase. Even if fresh emergency expenditures are met through reorientation, any further increase in borrowings from revenue shortfalls , escalates fiscal risks: Markets will interpret any further debt monetisation (fiscal dominance) negatively, especially with inflation pressures, leaving the RBI tackling disruptions in the domestic bond market.
India is neither rated investment grade, nor has sound fiscal position, and its fiscal policy framework remains inadequate, i.e. fiscal rules (FRBM Act) await revision, a credible medium-term debt redemption plan (estimated 90 percent of GDP this March) is non-existent. Were these in place, publicly shared, interest rate adjustments required would be less.
As can be seen, tightening policy strings risk higher output sacrifice and wider gap to recover ahead. The only passage out of this quagmire is quick, effective control of the pandemic. There isn’t another option. Vaccination should accelerate of course, but it will take time to impact.