Flexibly targeting inflation is consistent with a demand stimulus, says Ashima Goyal.
India is doing well compared to most countries, but industry and the investment climate is still weak, so low global demand is a risk. Macroeconomic policy, therefore, needs to deliver a demand stimulus. This is all the more urgent since employment growth is also weak. A thin quarterly employment survey available shows employment growth remained below the 2010 levels. There was a rise in 2015 but the fall in export growth hit it again. There is excess labour supply especially because 10 million young people enter the labour force every year. Interest rates have been too high ever since 2011.
Apart from international shocks, the reason was the fight against Indian inflation which has been high since 2007. In 2014, we committed to flexible inflation targeting. The target variable is headline consumer price inflation, including commodity prices, since these are dominant influences on consumer inflation expectations. Inflation targeting will work if it can reduce and anchor these expectations despite a future rise in commodity prices. This also requires supply-side action to ensure food inflation, to which household consumption baskets are very sensitive, does not rise above double digits. In the transition it requires food inflation to come down and remain low for some time. Despite two below-average monsoons food inflation has remained below double digits.
Headline inflation fell with food inflation and fell sharply in 2014 with the collapse in oil prices. Core CPI was sticky at around eight per cent over July 2012 to May 2014. It was feared this reflected skill shortages in services such as housing and education but it also fell suddenly with the sustained fall in food inflation, suggesting inflation expectations were the dominant component. It followed a fall in headline CPI after three months.
Headline inflation fell 50bps to 5.2 in February, within the inflation target range of six-plus-minus two per cent. Oil prices are expected to remain low -- the recent rise is good for long-term sustainability. The monsoon is expected to be good. These beneficial supply shocks can bring inflation down further without a demand squeeze.
Indeed, the inflation targeting framework itself suggests a demand stimulus is required. A global demand shock reduces the natural rate, requiring a stabilising fall in the policy rate to raise domestic demand (in interest sensitive components such as housing and consumer durables).
There is room for a 50 basis point cut, which will rise if inflation falls further. Flexible inflation targeting in particular, gives the freedom to raise the weight given to the output gap.
Although core CPI has been somewhat sticky between four and five per cent since August 2015 it can fall as it did earlier, after a further fall in household inflation expectations.
If the inflation-targeting logic of certain response to a rise in expected inflation is internalised, and if food price inflation is contained below double digits, a future adverse supply shock need not raise the general price level. Establishing low inflation expectations need not require a long period of low inflation.
For a long time, India was an outlier among emerging markets, indeed in the world, in terms of relatively higher inflation. But in the recent period, although soft oil prices and a global slump are keeping inflation low worldwide, it has become positive in Russia and Brazil, possibly because their currencies are depreciating. Relative rupee strength is also going to keep Indian inflation low.
Equity inflows have come back strongly on India’s better long-term prospects after pulling out early in the year due to global risk-off. This is the normal pattern earlier also, during rising global risk. The January-February hysteria is over. Chinese markets have calmed down, and the Fed committed to a slower rise in rates. If the rupee depreciates only enough to maintain competitiveness, it will not add to inflation.
The government sticking to the fiscal consolidation path in the Budget also removes another source of inflation. There is a view that the adherence is superficial -- a relative rise in consumption expenditure is potentially inflationary. But the Pay Commission-induced increase in urban consumption will only raise industrial output, given excess capacity in industry. It will be a useful demand stimulus.
The Budget has been criticised for not increasing rural spending enough. There is a large increase in the past two years, after a fall in the first year of this government. This is required given poor monsoons and rural distress. But it is targeted towards irrigation, roads, interest subsidy, all of which improve agricultural supply-side response.
Large, poorly targeted amounts pumped into rural areas without improving the supply side, in the United Progressive Alliance years, only increased inflation. Since more funds are going towards consumption, the Budget relies on departmental market borrowings to maintain investment. This is feasible since private investment and borrowing is low. So investment that relieves supply-side constraints is maintained in roads and railways despite a rise in consumption expenditures and sticking to deficit targets.
Given the importance of supply-side constraints for Indian inflation, the right kind of fiscal-monetary coordination is essential to win the battle against inflation and yet sustain growth. As long as the government acts to reduce inflation on the supply-side, monetary policy has room for accommodation.
The commitment to reduce the liquidity deficit will also help soften interest rates. The RBI had shifted in 2011 to keeping markets in deficit mode since this was thought to help transmission. But banks were not able to internalise that now the rate was the indicator of liquidity conditions, not liquidity itself.
There are structural reasons for this failure. For example, the absence of a benchmark rate meant bilateral rates could rise too much. Forecasting of liquidity shocks was still not good enough, given large shocks from fluctuations in government cash balances and foreign flows.
Even as money markets are further developed, given success in keeping call rates near the repo rate, softer liquidity need not imply large interest rate fluctuations. The narrowing of the repo-reverse repo band implies rates will not drop by too much, even if they fall towards the reverse repo rate. Moreover, research suggests transmission is better when rates and liquidity quantity work in the same direction.
Indian macroeconomic policy is in a position to balance negatives with compensating positives, which is the essence of stabilisation.
The writer is an economist.