Opinion | Expansionary fiscal policy to restrict the room for future monetary easing

Gaurav Kapur

Policy events over the first half of February will set the contours of fiscal and monetary policy for the coming financial year. Of particular importance will be the feedback of the fiscal stance on monetary policy, particularly in determining the space for easing. The recent inflation data shows that one thing is certain—the monetary policy stance will turn less hawkish. Forward guidance in the form of “calibrated tightening” is likely to be moved back to a data dependent path characterized by a neutral stance.

However, before the February monetary policy committee (MPC) meeting, the central government will present its interim budget. Going by the current trends in monthly tax collections, it is likely that the fiscal deficit target of 3.3 percent of the gross domestic product (GDP) for the current year would be breached, making it the second successive year when the government missed the target.

For the coming fiscal, there are enough indications that the government will announce measures to support the farm economy and counter the narrative of farm distress in the run-up to the general elections. With three more states announcing farm loan waivers post the December state elections, the likelihood of the central government following up with similar or other direct income transfer measures has increased significantly. Thus, it appears that the interim budget may postpone any significant fiscal consolidation, thereby raising concerns among the MPC members about fiscal expansion at a time when the economy is growing close to its potential.

A basic estimate of fiscal deficit, based on tax revenue growth of about 15-15.3 percent (reflecting tax elasticity in recent years w.r.t to nominal GDP growth) and a 0.3 percent of GDP increase in revenue expenditure in FY2019-20 (on account of populist measures) gives us a number of about 3.5 percent (assuming 11.5 percent nominal GDP growth, overall budget size of 13 percent of GDP and more realistic disinvestment target). That compares with a target level of 2.8-3 percent of GDP required for reducing the central government debt to GDP to about 40 percent by FY2022-23 under the FRBM legislation. Fiscal slippage by states can also be expected compared to their combined budget deficit target of 2.9 percent of GDP, as they too are expected to increase spending ahead of general elections and key state elections in 2019.

The possibility of fiscal slippage and a generally expansionary bias was flagged as an upside risk to inflation in the December MPC statement. And, in the April 2018 Monetary Policy Report, RBI had estimated that a one percentage point increase in the combined fiscal deficit of centre and states could lead to a 0.5 percent increase in inflation and exert pressure on borrowing costs. Therefore, going forward, fiscal profligacy is likely to emerge as a dominant risk to the otherwise benign inflationary conditions. An expansionary fiscal policy with an increase in welfare spending without associated cuts in existing subsidies would be a cause for concern, as that could stoke consumption and inflation while hampering capital formation.

Aside from fiscal policy developments, the MPC would draw comfort from the fact that the headline consumer price index (CPI) inflation in its last two prints has softened further, moving closer to the lower end of the 2-6 percent target band. However, the fact that core inflation remains high and sticky, closer to the higher end of this band, would call for continued vigilance. Depressed food prices and a sharp decline in global crude oil prices allowed the headline CPI inflation to ease to 2.19 percent in December, but core CPI inflation (excluding food and fuel), remains high at around 5.74 percent.

Persistence of high core inflation is a major risk in ensuring that the headline CPI inflation remains anchored at around 4 percent on a sustainable basis. Any reversal in oil or food prices can easily push overall inflation into a higher trajectory. Also, the December CPI reading appears to be the bottom and inflation will gradually move up. For instance, over the next couple of months, the base effect will push the headline higher. Food price inflation could see some bottoming out as well on the back of increased procurement by the government at higher minimum support price and on account of lower winter crop sowing.

In the February MPC meeting, therefore, based on recent data, stable oil prices and considering that inflation over the next 6-9 months would remain below the 4 percent target, the policy stance is likely to be changed to “Neutral”. That would make the future rate actions dependent on data and the balance of upside and downside risks to inflation. More importantly, such a shift in stance will bring back the possibility of a rate cut or two in the next fiscal year, considering that real policy rates remain high compared to the preferred neutral rate range—seen somewhere between 1.25 -1.75 percent.

The timing of the actual rate action, particularly a rate cut would, however, be contingent on the balance of risks to inflation, such as oil price dynamics once the US sanctions on Iranian exports become binding from May, prospects of monsoon dependent summer crop output and the strength of general demand conditions supporting core inflation. The US Federal Reserve’s pace of monetary tightening and global liquidity squeeze would have a bearing too. Fed Chairman Jerome Powell has indicated that the US central bank can be more patient in hiking rates in 2019 and can even reduce the pace of its quantitative tightening if the global slowdown risks spill over to the US.

Therefore, the space of monetary easing, among other things, would depend upon how significant and persistent fiscal slippage turns out to be. At this juncture it appears that the room for monetary accommodation would be limited as the MPC looks to balance the impact of an expansionary fiscal policy.

(The author is the chief economist of IndusInd Bank. Views are personal.)