Linking inflation persistence in India to fiscal policy credibility

An interesting paper by RBI econs – Pankaj Kumar and Pratik Mitra

They say tight monetary policy is ineffective if fiscal policy is easy. This is well-known. They expand this to show that inflation persistence in India is because of continued fiscal slippages.

In the recent past India has experienced high and persistent inflation. In response the Reserve Bank of India cumulatively raised the cash reserve ratio by 100 basis points and the policy rate (repo rate) by 375 basis points between January 2010 and October 2011. Despite these policy actions, the inflation rate however continues to remain stubbornly high. What explains our current inflation predicament?

This paper finds that large contemporary government deficits unaccompanied by concrete prospects for future government surpluses promote realistic doubts about whether monetary restraint must be abandoned sooner or later to help finance the deficit. The result will be a rise in inflationary expectations in spite of current money-supply restraint- a bout of unpleasant monetarist arithmetic. In sum, it is insufficient to announce and maintain restrictive monetary policies unless accompanied by a coordinated reduction in the budget deficits. Prudent anti-inflation policy includes containment of the deficit.

The authors could have used simpler language. It led to some confusion over first reading..

They say there is no single country where inflation has arisen in a fiscal sound country:

In fact, major inflation episodes around the world have ultimately resulted from fiscal problems and it is hard to think of a fiscally sound country that has ever experienced high and persistent inflation. So long as the government’s fiscal house is in order, people will naturally assume that the central bank should be able to stop a small uptick in inflation. Conversely, when the government’s finances are in disarray, inflation expectations can become “unanchored” very quickly. But this link between fiscal and monetary expectations is too often ignored by both policymakers and the popular press.4

The basic point is that fiscal deficits today must be paid for by taxes, money expansions or lower expenditure tomorrow (the government’s inter-temporal budget constraint). If one assumes any reasonable termination of the rising debt/GDP ratio, whether because of a limit on incentive damaging taxes, then money financing is eventually required in the absence of quite implausibly severe cuts in public expenditure. This means a rise in future inflation is worse than the moderation in current inflation from current money-supply restraint. This analysis was spread widely by Sargent and Wallace (1981) in their well known paper ‘Some unpleasant monetarist arithmetic’. From the government’s inter-temporal budget constraint, if the fiscal house is not in order in the present and the future, then this implies monetary restraint will be abandoned sooner or later to ensure solvency.

This would undermine credibility of the monetary regime as inflationary expectations would remain elevated. Hence the ‘unpleasant’ policy lesson that the budget deficit must also be cut back to make a monetarist inflation-control programme work. By implication contractionary monetary policy signalling the authorities’ wish to halt inflation may not be credible unless accompanied by a coordinated reduction in the budget deficits. Therefore, in order to establish counter-inflationary credibility it is not sufficient just for the monetary authority to be responsible. We need fiscal stance to be responsible too.

They nicely show via a graph  how inflation persistence has risen whenever deficits have risen. The proxy for policy credibility is basically fiscal. It would have been very interesting if a comment was made over RBI’s credibility over managing inflation as well. For instance. the average inflation since 1982 is 6.9% which is way higher than RBI’s comfort zone of 5-5.5%:

Price stability has been an important objective of monetary policy in India. In fact, India’s inflation performance compares favourably against other emerging market economies. The 1950s witnessed average inflation of less than 2 per cent, but with considerable variation in yearly inflation. During the 1960s, the average decadal inflation edged up to 6.3 per cent, on account of wars and unsatisfactory agricultural supply position. Like most other developed and developing countries the decade of 1970s was the most turbulent period when it comes to India’s inflation history. The average inflation was 9 per cent in that decade.

Figure 1 shows all commodities WPI inflation since the early 1980s (summary statistics in Table 1). We have split our sample 1983:4 to 2011:1 into different segments with each segment corresponding to a statistically distinct mean of overall inflation compared with the adjoining segment. This periodisation of the data is based on the Bai and Perron (2003) test of multiple structural breaks at unknown dates where the optimal breakpoints are estimated from the data itself. For the period beginning April 1983 up to January 2012, average headline inflation measured in terms of year-on-year increase in all commodities wholesale price index (WPI) has been 6.9 per cent. While the primary (7.9 per cent) and fuel groups (9.0 per cent) have been the high and volatile components, the manufactured group (6.1 per cent) component has been low and stable.

Agreed much of this is to be blamed on fiscal. But where does RBI credibility stand currently?

Overall, a nice paper touching on an important issue..

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