Through Alok Sheel

As the May CPI figures raise fears of stagflation and the US Fed announces overnight that it will begin to take small steps towards reducing bond purchases, new questions arise as to the future. how macroeconomic policy in India should respond.

Although its death rate measured as a proportion of the population during the first wave of the Covid pandemic was very relatively low compared to other major economies, India nonetheless experienced one of the largest growth declines in the country. during fiscal year 2020-21. The likely reason was that its economy was already in the throes of a marked economic downturn when the pandemic hit. In addition, unlike other economies that imposed strict restrictions, budget support measured against lost output was modest.

Most of the stimulus measures announced in the first wave of last year were in the form of liquidity support to already over-leveraged companies. Little has been done to put money in the hands of those who have lost their incomes and jobs, as has been done in the United States, Japan and Europe which have imposed strict containment measures. According to IMF calculations, India’s fiscal stimulus, including revenue losses, amount to just 3.3 percent of GDP. Among the G20 countries, only Mexico, Saudi Arabia and Turkey injected less fiscal stimulus.

The stimulus proposed in the 2021-2022 budget is equivalent to an additional 1.5% of GDP if we assume that this corresponds to the difference between the pre-crisis expenditure growth of 12% and the expected real increase. The cumulative stimulus for the two years is therefore estimated at 4.8% of GDP, against 8.8% of potential output loss during these two years estimated by the IMF on the basis of its growth projections in the Outlook for the year. global economy before the January 2020 pandemic. There is therefore a strong case for additional fiscal stimulus of up to 4% of GDP. The production loss will likely be even higher, as the above estimate was made before the devastating second wave, with earlier projections for 2021-2022 having been revised downwards by several agencies.

The fiscal stimulus in the 2021-2022 budget mainly takes the form of increased infrastructure and investment spending, which takes time to start, rather than income support whose impact on consumption and the demand is immediate. Most of the additional tax incentives could take the form of income support for people made redundant, the self-employed in small businesses who have lost their means of income, and for families who have lost salaried members. While some assistance has been given to the poor through the provision of free food grains, much remains to be done in terms of GDP share, as noted above.

The nominal budget deficit is undoubtedly already high relative to the targets set, and inflation is high, so it can be argued that there is no fiscal room for aggressive stimulus. Much of the increased deficit, however, is cyclical rather than structural, owing to the sharp decline in revenues associated with the collapse in growth. This component of the deficit will automatically reduce when growth picks up. Policymakers are well advised to heed John Maynard Keynes’ advice that “The boom, not the recession, is the right time for austerity in the Treasury. “

The decline in growth is unprecedented and calls for extraordinary measures. Unless decisive action is taken to revive growth, the budget deficit would continue to widen under the impact of revenue shocks in the absence of large cuts in social protection spending. Such extraordinary steps were taken by several other countries, including large-scale government borrowing as central banks stepped in to buy sovereign debt to keep interest rates low. This option should be seriously considered by the government bearing in mind the gravity of the situation. This could weaken the rupee. But it could also have a beneficial impact on the lagging export sector, as large capital inflows in recent years have tended to make the rupee appreciate in real terms.
terms.

This raises the question of how to fight inflation. The RBI’s monetary policy committee met recently and is expected to keep policy rates unchanged. Monetary policy was already very accommodating, with a real repo rate in negative territory. While the Fed chairman announced that it would start taking small steps towards cutting its bond purchases and that U.S. interest rates could rise earlier than expected sooner in the wake of a strong US recovery, the threat of capital outflows looms over the horizon again after declining for a while, making it difficult to cut rates. The central bank risks being caught in the familiar trilemma, with external and domestic monetary policy constraints pulling in opposite directions. Inflationary pressures add to RBI’s woes. In May 2021, the CPI exceeded the RBI’s high range target of 6%, indicating the possible emergence of stagflation, the combination of high inflation and low growth that is a nightmare. for the central bank, because you have to raise rates to contain inflation and lower them to stimulate growth.

With stagflation and trilemma rearing their ugly heads at the same time, it’s hard to see what more the central bank can do. Supply-side measures taken by the government, such as releasing food stocks, lowering fuel taxes and easing pressure on supply chains, rather than monetary policy, should be the political instrument of choice to control inflation. This, combined with the persistent build-up of bad loans that keeps monetary policy transmission channels weak, makes fiscal policy the only game left at present to deal with the triple whammy of inflation, weak growth. and the threat of capital outflows.

(Alok Sheel is RBI Professor of Macroeconomics, ICRIER. The views expressed are those of the author.)