Tuesday, June 30, 2009

Macroeconomic policy dilemmas

Indian macroeconomic policy is battling peculiar dilemmas. CPI inflation has crossed double digits even as WPI inflation is negative! As if that were not enough, yellow patches abroad continue to cast a jaundiced eye on green growth shoots in India. So fiscal policy has to nurture these shoots, and yet control runaway deficits. Thinking about Indian structure in the context of globalisation is the way to find solutions for monetary and fiscal policy alone and in combination.

Retail inflation is high because food price inflation is high. This is due to a flawed procurement price policy, exchange rate depreciation further pushing up high border prices, and inefficient wholesaling. These are not factors that a compression of demand can cure. But since food continues to have a high share of average consumption baskets, food price inflation tends to push up wages and the general price level. Delicate balancing is required, therefore, to anchor inflationary expectations and yet stimulate a supply side response.

Inadequate attention to such structural factors has in the past triggered and prolonged slowdowns. The typical response to food and oil price shocks has been a monetary tightening, together with administrative interventions that created inefficiencies over time.

Hidden charges raised costs making inflation sticky, while populist giveaways deteriorated government finances. So further tightening followed. More nuanced policies that shift down the supply curve are required. Short-term, such policies are changes in tax, tariff and exchange rates, while long-term policies would raise productivity.

The current crisis has made possible a break in the vicious cycle of loose fiscal and tight monetary policies. Post-Lehman, the US pushed for a global stimulus. The argument was with output below potential in most countries a concerted push was required. This was a big change from the normal pressure on emerging markets to tighten their belts in crisis times.

For once they pushed us in the right policy direction since they were themselves involved. World output may be below potential today but it is always below potential in populous emerging markets in a catch-up phase. Supply bottlenecks, however, push up an elastic supply curve. Therefore, policy must act in a coordinated way to keep demand high but remove supply bottlenecks. If supply is elastic a demand tightening has a large output cost with little reduction in inflation.

The concerted boost, as the RBI adopted unusual policies and accommodated indulgent fiscal giveaways, has compensated somewhat for the fall in private demand and kept Indian growth rates at respectable levels. But this combination cannot continue indefinitely. The worst outcome will be a return to tight monetary policy while fiscal deficits continue to balloon.

The budget should present a credible path of fiscal consolidation, showing how government expenditure will shrink as private expenditure rises. It will be credible if, first, detailed expenditure planning gives expenditure caps and targets to ministries. Second, strict prior funding norms are instituted for populist transfers while productive expenditures that relieve supply bottlenecks are increased.

Third, better accounting, reporting and management systems to ensure expenditures are actually made, with minimal delay and waste. Then impact on green shoots would be maximal and real improvement replace cosmetic compliance with the FRBM. This would be the best fiscal stimulus.

What about monetary policy? Lower interest rates reduce pressure on government borrowing. But there is little leeway for further cuts in short-term policy rates. Considering an average inflation rate, across components and time, real short-term interest rates are negative. The current structure of inflation is doubly unfortunate. High CPI inflation means savers face a negative real interest rate. Low WPI or producer price inflation means industry faces high positive real interest rates.

But real loan rates are not that high since the negative inflation is just a statistical base effect. CPI has more lags but should reduce in future. Although high food price impact inflationary expectations, negative external demand shocks and lower commodity prices help to contain them.

The real action now has to be in coaxing cuts through the structure of interest rates. Loan rates are sticky but are slowly coming down. Leaving rates to banks, policy should focus on the tardy credit channel. Apart from general liquidity support, special schemes can alleviate blocks in credit flow to export firms and MSMEs. These should not force credit to unviable firms, but compensate for systemic fear-driven freezing. Talk of withdrawal of liquidity is dangerous until recovery is firmly established. The Great Depression was prolonged because of premature withdrawal of stimulus. Much of the liquidity is being re-absorbed in the daily LAF (liquidity adjustment faci

The other important contribution the RBI can make is to clearly communicate its current support for the government’s borrowing programme, to abate market pressure on medium-term interest rates. The traditional RBI stance always pointed to problems created by large government borrowings, thus enhancing market hysteria. But this is not the time for that. The RBI has many instruments such as OMOs available to lower rates through the term structure.

The annual monetary policy, in a good beginning, made this clear and pointed out that market absorption of fresh government securities would actually be lower than in recent years of high inflows.

Some general lessons can be drawn for the interest rate channel. Banks pass on rate rises faster. So the tug on the string should be mild. Banks and markets will help push it through the system. A gradual rise can ameliorate a boom without causing a crash. While the mild policy rate rises over 2004-07 sustained high growth but moderated housing bubbles, the sharp rise in 2008 punctured industrial growth. But policy rate cuts should be fast in a downturn.

If further cuts are expected, banks hold appreciating bonds rather than provide credit, consumers postpone purchases, and firms wait for lower loan rates. Banks moderate the spread of the cut, and therefore the shock of a large change in rates. Further marginal policy adjustments can depend on outcomes. Rate changes can be milder to the extent they are implemented in advance of the cycle.

No comments: