Monetary and fiscal policies need to go hand in hand

Rupa Rege Nitsure

The MPC (Monetary Policy Committee) of the Reserve Bank of India is facing a tough challenge even after changing its policy stance to ‘accommodative’ in June 2019 and steadily reducing the policy rate by 135 bps last year.

The economic growth momentum has stayed significantly weak. At the same time, upside risks to inflation have increased due to supply shocks and administered price adjustments. Against this backdrop, the MPC is expected to manage inflation without losing sight of weak growth and lingering financial sector fragility.

First of all, the MPC has to accept that this is an exceptional phase for the Indian economy with the lowest real GDP growth in 26 quarters, the slowest real investment growth in 22 quarters, the weakest expansion in bank credit and NBFC (non-banking financial companies) loan disbursements in 10-11 quarters. Add to that unemployment at a 45-year high and the capacity utilisation rate of industry hovering near 68-69 percent due to sluggish demand.

Given this background, there is tremendous uncertainty about the level of “potential or trend output” in the economy, which has made reliance on measures like “output gap” problematic. One has to exercise caution before taking recent green shoots of revival in some HFIs (high frequency indicators) as a beginning of the cyclical recovery.

The business inflation expectations survey of the IIM (Ahmedabad) released on February 3 says “companies’ sales perception data still does not show clear signs of recovery. The sentiment of profit margin has remained pessimistic and unchanged”.

Despite lingering growth weakness, inflation has surprised negatively. The headline CPI (consumer price index) inflation spiked to 7.35 percent in December 2019 due to a pick-up in food inflation since October, partly aided by an unfavourable base effect.

Core inflation too inched up in November-December, 2019, due to higher costs of transportation, thanks to the global crude oil price shock and increased telephone charges (both landline and mobile).

Luckily, in January 2020, food prices moderated slightly after a sequential fall in prices of tomatoes, potatoes, onions (vegetables of mass consumption) and select beverages and pulses.

While CPI inflation will continue to remain way above RBI’s acceptance level in January 2020 too, it is expected to moderate at a faster pace from February onwards on the back of many healthy underlying trends like improved Rabi sowing, elevated water reservoirs and a favourable base effect.

Core inflation excluding the administered prices of transport and communication services will also stay weak on the back of fragile demand conditions. Another supportive factor from the inflation perspective is the global Brent crude price, which has eased from $70 per barrel in December 2019 to $54-55 level currently.

It may be noted that during the current exceptional phase, the existence of high food inflation or administered prices of a few services will not give rise to “generalised inflationary pressures” due to fragile growth and job market conditions that have reduced the bargaining power of trade unions even in the organised sector.

Interestingly, this is the first policy review post the announcement of Budget for 2020-21, in which the government has postponed fiscal consolidation in the interest of growth. Despite the evident pressure on revenues, the government has increased spending on agriculture, irrigation, rural development, road construction, smart city mission and the like. The government expects nominal GDP (gross domestic product) growth to rebound from 7.5 percent in FY20 to 10 percent in FY21 on the back of continuation of structural reforms, normalisation of financial credit and transmission of repo rate cuts earlier.

While transmission from the credit segment has stayed depressed, that of the bond segment has definitely improved. Interestingly, the 10-year bond yields have slid 24 basis points since mid-December. Yields eased further after the Budget as the government’s gross borrowing plan at Rs 7.8 lakh crore met market expectations.

While there is no scope for a repo rate cut at this stage, the stance of policy has to stay at “accommodative” to support the process of “transmission” through bond segments.  Also, there should be transparent “forward looking guidance” about the RBI’s open market debt-purchase programme (Operations Twist) to help market participants understand the effectiveness of this measure in managing the yield curve.

An accommodative monetary policy with a temporary pause in the rate-cutting cycle is the need of the hour as this will strengthen the government’s stimulus package announced in the Budget.

Rupa Rege Nitsure is Group Chief Economist, L&T Financial Services. Views are personal.