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Rathin Roy: Inflation and policy coherence

On the fiscal front, the one thing this government must NOT do, whatever the excuses or inducements, is to relax its fiscal deficit target for 2015-16

Rathin Roy 

Rathin Roy

It is now clear that India is not growing as it should. Nominal gross domestic product (GDP) growth is estimated to be 7.4 per cent and real growth 7.2 percent for the first two quarters of this financial year by the Central Statistics Organisation. The underlying story is far more dramatic when the numbers from the second quarter of 2013-14 to the second quarter of 2014-15 are examined. Over this period, nominal GDP growth has collapsed from 13.6 per cent to six per cent, even as real growth declined by just one per cent.

For this to happen, the economy must be undergoing rather severe aggregate disinflation. However, the consumer price index (CPI) remains at or above four per cent in each quarter of the same period. What has collapsed, is the wholesale price index (WPI), which measures changes in producer prices; this has declined by eight percentage points.

The combined result is that the difference between real and nominal GDP growth this fiscal is likely to be close to zero. This is because the GDP deflator, which is used to convert nominal to real GDP, reflects roughly 70 per cent of the WPI and 30 per cent of the CPI. This has declined by 6.5 per cent over the same period. As a result there is likely to be little difference between nominal and real GDP growth this financial year unless there is some dramatic inflation in producer prices in the next two quarters.

This is not just a statistical conundrum. Growth in real GDP measures increases in the total output of goods and services in the economy were prices to remain unchanged. Nominal GDP measures increases in the value of that output (quantity sold x price). It is this monetary value of output that is targeted by macroeconomic instruments; this is also what impacts producer confidence and profitability. This is, thus, a dangerous situation, where a relatively small decline in real GDP growth magnifies into a precipitous decline in nominal growth.

This has major policy implications. First, fiscal deficit targets are set assuming that nominal growth would be somewhat higher than real growth. When this does not happen, government must scramble to find resources to meet its fiscal consolidation target, as I explained in my last column ('Disinflation and fiscal resilience', 10 December, 2015). If this situation continues, then the task of fiscal consolidation going forward will be much more difficult than has been the case historically.

Second, this brings into serious question the validity of the inflation targeting exercise as it is presently carried out. The bank rate was nine per cent in the second quarter of financial year 2014. This has declined to 7.75 per cent in the second quarter of 2015. With CPI inflation at no more than five per cent, this means a comfortable real rate of return for savers. But with the WPI and the GDP deflator both in negative territory, this means that the cost of capital for investment is astronomically high. The average lending rate is around 11 per cent, and even priority sector loans incur interest rates above 10 per cent. This is a terrible situation for a growing economy to be in, and the central bank would be expected to act to correct the situation. However, the Reserve Bank of India (RBI) is not inclined to reduce interest rates because CPI inflation is at five per cent and the RBI is aiming for the midpoint of the inflation target range, i.e. four per cent.

There is, therefore, a complex macroeconomic challenge on the horizon. Marginal policy adjustments will not do the trick. Bold actions are required.

On the fiscal front, the one thing this government must NOT do, whatever the excuses or inducements, is to relax its fiscal deficit target for 2015-16. Instead, what needs to be done is to examine whether the method of calculation of the current GDP deflator is fit for the purpose. The RBI targets CPI inflation. Hence, notwithstanding what statistical purists assert, policy coherence requires that the GDP deflator must be very closely aligned with, if not identical to, the CPI. Nominal GDP will then be back in the low double-digit zone within which our macro-fiscal instrumentation has been devised to work. This will be a much more plausible correction than crying off fiscal responsibility, given the poor quality of central government spending and a track record of broken promises on this score.

The RBI will also need to look afresh at its inflation targeting mechanism. The analytical work on which the current inflation targeting band is based provides no technical justification for the target other than some references to what exists in other countries and what previous committees have recommended. An inflation target of four per cent is secured through interest rate policies that result in average lending rates close to 12 per cent. It is little wonder that investment demand is flat. If the RBI does not have the capacity to lower interest rates consistent with four per cent CPI inflation, then government must re-examine the policy justification for a higher target rate within the two to six per cent band. This is, finally, a political decision and the collapse in nominal growth rates provides a sufficient analytical basis for urgent reconsideration.

The writer is director, National Institute of Public Finance and Policy

First Published: Thu, January 07 2016. 21:44 IST