India: Taming inflation without hurting growth

Economic decision makers face a problem. They make tradeoffs between alternative solutions but very few are win-win. Most involve optimizing for economic harm against benefits. Sadly, quantifying tradeoffs remains captive to data and computing constraints in these pre-quantum computing times. The fallback is to rely on gut instincts, ideology, or copycat solutions- none of which guarantee success.

Inflation management in the contemporary world is a good example. Gut instincts honed by decades of fiscal fundamentalism would lower the fiscal deficit, reduce liquidity, and ramp up interest rates to squeeze demand down to balance with supply. This is what the United States (US) is attempting. The federal funds rate increased from zero percent in end 2021 to between 1.5 and 1.75 percent during 2022 with the Federal Reserve committing to further increases to keeping inflation within 2 percent (long term target) versus expected levels of 7.9 percent in 2022.

This strategy makes sense if inflation is running at 8.3 percent (core inflation 7.4 percent August 2022), employers cannot fill vacancies, wage increases are getting baked into the upward price movement and the economy is growing at a relatively high 1.7 percent (Q2 of 2022) versus forecasted growth of 2.3 percent in 2022 slowing to 1 percent in 2023.

India- contextually different from advanced economies

In comparison, India faces the opposite problem of chronically low employment, high fiscal deficit (targeted 6.4 percent in fiscal 2023 versus the norm of 4 percent of GDP), low private capital investment and a slow post-pandemic economic recovery. GDP will reach pre-pandemic levels (FY 2019-20) in constant terms only at the end of this fiscal year. Inflation at 6.7 percent forecasted for 2022-23 is higher than the acceptable norm of 4 percent. Also, unlike the US or Europe, India has very shallow and leaky social and unemployment support systems. Per capita income (PPP) at 10 percent of US and 15 percent of EU levels, vastly reduces individual resilience to economic shocks.

Since the pandemic, the Union and state governments have supported the bottom three quintiles through direct income transfers to 70 million farmers; free cereals and lentils for 800 million people under the Right to Food legislation; rural works programs to provide income support; freezing the retail prices of fertilizers and reducing excise tax on fuel to reduce the retail price- these measures exert fiscal pressure, despite buoyant tax revenues partly fed by inflation.

A normalizing globe

The global economic outlook is uncertain. Output is expected to reduce from 3.2 percent in 2022 to 2.9 percent in 2023 with a downside of 2.6 and 2 percent respectively. Nevertheless, the resumption of food exports from Ukraine and the rebalancing of military capability between Ukraine and Russia portend a turn to diplomacy from hostility. Near-certain continuation of President Xi for a third term is another positive. Closer home, the continued disengagement of Indian and Chinese troops at friction points along the “line of actual control”, reflects mature diplomacy replacing transactional misadventures.

In summary, the external systemic constraints on India’s growth could weaken. We can hope for a quickening growth phase over the next five years at above 6 percent versus global growth at around 3 percent per year.

The trade-off between growth and taming inflation

What then is the correct trade-off between inflation taming base interest rate increases by the Reserve Bank of India and growth encouraging retail interest rate levels? Union Finance Minister N. Sitharaman, perceptively remarked, at a recent  ICRIER seminar , that monetary policy acting alone could be an ineffectual tool for taming inflation in the Indian context.

We need not blindly synchronize with changes in central bank base rates in advanced economies. Interest rates in India are sticky and slow to change in response to fiscal signals. Consider that during the fiscal years 2015 to 2019 inflation was below 6 percent- the normative outer limit, and for two years even below the 4 percent norm. However, the Repo Rate took two years to decline from 8 percent (April 2014) to 7 percent (April 2016) and remained above 6 percent till April 2019.

Sticky RBI base rate warps perceptions of future economic prospects

In comparison, the US Fed Funds rate remained at 0.25 percent from 2009 till December 2015; below 1 percent till March 2017; between 1 to 2 percent till June 2018; rose to 2.5 percent by December 2018, before declining again to zero percent by March 2020.

A difference of 5 to 6 percentage points between the fed rate and the repo rate is understandable till 2014-15 because inflation in India remained high at between 9 to 10 percent. But even post 2014, despite the decline in global fuel price and inflation, the repo rate remained high at between 8 percent (March 2014) to 6 percent (April 2019) and could have retarded growth (constant terms) which slowed from 8 percent in 2015-16 to 3.7 percent in 2019-20.

The fear of Rupee depreciation

Aversion to reduce the RBI rate decisively, stems from the need to maintain a cushion for higher inflation levels in India and cater to the risk perceptions of overseas investors, whose flight can trigger currency depreciation. Also, over 2017-2020 the instinct to preserve a higher margin for publicly owned banks to re-build their reserve capital and enable write-off losses from high levels of non-performing assets over the years, similarly provided a floor for retail lending rates.

Bank nonperforming assets have reduced to 5.9 percent (March 2022) well below the double-digit level in 2016. However, anecdotal accounts of a reluctance to lend to small business versus continued asset accretion in “presumed to be safe” large industry, does not augur well for jobs, growth, or sound credit risk management.

High bank lending margins add to inflation

The unfinished task of reducing the margin charged by publicly owned commercial banks between their cost of funds and the interest earned from lending, remains captive to high operational costs, and adds to inflation pressure. The P word (privatization) remains out of sync with the emerging ethos of “big” government in India. This makes public sector efficiency enhancement critical. Digital banking can induce competitive pressure and lower operational costs.

Synchronous domestic fiscal policy can tame inflation

The finance minister advocated a non-monetary policy mechanism for taming inflation. Presently the lack of synchrony across the Union and state governments in levying tax on inflation-inducing commodities, like petroleum fuel, encourages “tax gouging.” The efficient way of achieving synchrony is to bring petroleum fuels under GST. Sadly, in the existing environment of fierce political contestation this might be unworkable.

Institutionalizing a Carbon Tax Council could help

In the meantime, why not constitute a Carbon Tax Council (like the GST council) of state finance and environment ministers, with the Union finance minister and the Union Environment minister as co-chairs, to work towards a harmonized VAT and Excise tax on petroleum fuels. Tax on such fuel is equivalent to a tax on carbon emissions with global benefits.

This entity could start by reviewing and unifying India’s framework for tax on fossil fuels (coal is already under GST) and then go on to consider a common framework for carbon pricing till 2030. The Council could also determine how import and export tax and cess levied on fuels by the Union government fit into the “tax sharing” paradigm of “co-operative federalism” evoked by Prime Minister Modi.

One nation One tax

Strong economic networks (the power and gas grid, national highway grid, rail services and airports) and the “one nation one tax” motto, exemplified by the GST, are the foundations on which a free and self-reliant (Atma Nirbhar) India can be built. But leaving fossil fuel-based tax sources amounting in fiscal 2021-22 to Rs 3.6 trillion (Union excise duty) and Rs 2.6 trillion (State VAT), together around 3 percent of GDP, out of synchronous tax setting, speaks ill of an integrated economy.

Non-monetary policy initiatives, including, reducing the fiscal deficit, which is linked to the current account deficit, will assist the RBI in fine tuning its interest rate policy. It treads a fine balance between stifling nascent growth and doing the minimum required via monetary policy to manage inflation. The fuzziness is pronounced because monetary policy kicks in with a lag only once retail interest rates get revised but the impact from investor perceptions is immediate.

The cost of a slower, asynchronous, interest rate increase, relative to global trends, is the possible erosion of foreign exchange reserves, spent fighting currency depreciation post capital flight by cautious international investors, skittish at the prospects of high inflation, untamed fiscal deficits and growing current account deficits to follow, per the reflections of a former Governor RBI  on the 17 percent depreciation in the INR over three months – May to August 2013.

These metrics remain concerns even today. Possibly, moving directionally in global synchrony to increase interest rates but doing so only in baby steps, could bolster international investor confidence without derailing nascent growth.

This opinion piece first appeared in orfonline.org on September 17, w2022 https://www.orfonline.org/expert-speak/indias-monetary-plans-taming-inflation-without-inhibiting-growth/

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