Inflation again continues at higher levels and nobody is ready to believe that it can come down in the near future. One of the Deputy Governors of the Reserve Bank of India (RBI) has already hinted that money tightening policy will continue.
While the RBI is planning to announce its second-half monetary views and measures on October 25, it would be interesting to know that fiscal measures still continue to influence the monetary policy of the central bank and only a coordinated approach by the government and the RBI could bring down inflation.
A Working Paper published by the RBI titled “An empirical analysis of monetary and fiscal policy interaction in India” by Janak Raj, J. K. Khundrakpam and Dipika Das, tries to throw some light on the subject.
In a cross-country context, there has been a renewed interest in analysing the interaction between fiscal and monetary policies in recent years.
Several factors have contributed to this trend. These include: increasing independence of central bank in the conduct of monetary policy; stability and growth pact (SGP) and formation of European Monetary Union (EMU) under which individual countries pursue independent fiscal policies, but have a common monetary policy; and the demonstrated need for a coordinated response of monetary and fiscal policies during the recent global crisis.
This study analyses the behaviour of monetary and fiscal policies interaction in India using quarterly data for second quarter of 2000 to first quarter of 2010. It finds that, even after the elimination of automatic monetisation of fiscal deficit in 1997 and prohibiting RBI from buying government securities in the primary market under the Fiscal Responsibility and Budget Management (FRBM) Act from April 2006, “fiscal policy continues to substantially influence the conduct of monetary policy.” Specifically, the reaction of the two policies to shocks in inflation and output is mostly in the opposite direction. While monetary policy reacts in a counter-cyclical manner, fiscal policy reaction is primarily pro-cyclical in nature.
The authors suggest that expansionary fiscal policy is effective in raising the level of output over the potential level only in the short run. In the medium- to longer term, however, fiscal expansion leads to economic slowdown. It seems fiscal deficit leads to decline in savings and investment in the economy over the medium-term, besides crowding-out more efficient private sector investment by government consumption. “The positive impact of expansionary fiscal policy on output is highly short-lived, while there is a significant negative impact in the medium- to long-term”.
Incidentally, the government's bond auction devolved last Friday on fiscal concerns. The market expects a further increase in the borrowing plan of the government. It also anticipates a policy rate hike in another few days.
This uncertainty leads to nervousness in the market, where market participants bid for higher yields. They also believe that yields will move up as the government resorts to more weekly borrowings in the second-half of the financial year, which is traditionally considered as a ‘busy season' for businesses. As the market bid for a higher yield last week, the benchmark 10-year Government Securities (G-Sec) surged up. The RBI set the cut-off yields at 8.78 per cent for the 10-year G-Sec and 8.79 per cent for 7-year G-Sec. Since the announcement of the government's plan to borrow more at Rs.2.20-lakh crore in the second-half of the current financial year against Rs.1.67-lakh crore planned earlier, on September 29, the yield of the 10-year G-Sec moved up by 34 points, which ended at 8.78 per cent last Friday. This is not a pleasant situation for the RBI.
In India, several changes have taken place in the monetary and fiscal policy frameworks, particularly since the beginning of the 1990s. These include complete phasing out of automatic monetisation of fiscal deficit through creation of ad hoc treasury bills (also called ad hocs) in 1997 and prohibiting RBI from buying government securities in the primary market from April 2006 under the FRBM Act, 2003. Further, the operating procedure of monetary policy underwent a paradigm shift in the early 2000 with the introduction of liquidity adjustment facility and the interest rate channel becoming the main monetary policy signalling instrument.
These changes are quite significant and have altered the basic nature of the interaction between monetary and fiscal policies. However, the Central Government continues to incur large fiscal deficits, which has implications for the demand management by the RBI.
OOMMEN A. NINAN