Budget & oil prices goi needs to avoid premature fiscal tightening as rbi needs to keep an eye on inflation

Budget & oil prices goi needs to avoid premature fiscal tightening as rbi needs to keep an eye on inflation

A year is a long time in an uncertain world. Over the last year, India’s economic challenges have multiplied. Policy support that was wholly directed to revive an economy in the midst of its first annual economic contraction in three decades has to now simultaneously focus on a relatively high retail inflation that is sticky. The price of the Indian basket of crude, a popular gauge of inflationary pressure, is now around $87 a barrel, higher by about 50% over the last year. Therefore, RBI and GoI need to tweak their positions to simultaneously support economic growth and cope with an upward pressure on retail inflation.

The forthcoming Union Budget needs to be framed in the context of the last two years. Monetary policy has been the main tool deployed to revive the economy. Not only has the central bank’s policy rate at 4% been lower than retail inflation for long periods, market interest rates have been pulled down by expanding liquidity. Consequently, in the last two years, median-term deposit rates of banks for fresh inflows have fallen by 2.13 percentage points and average lending rates for new loans are now 1.97 percentage points lower.

There are two developments that indicate that monetary policy has run its course. Over the last two months the gap between the interest rates on short-term and long-term loans has widened as the threat of high global inflation influences the bond market, and also the expectation that there will be substantial borrowing by GoI and states. This shouldn’t deter either GoI or states. The economic priority remains reviving the economy as recovery has been uneven. Both contact-intensive services and private consumption remain below the pre-pandemic levels. The Omicron wave has just added to the stress.

The stickiness of core inflation around the 6% mark and a higher-than-anticipated nominal GDP growth will improve the deficit parameters of GoI and states. However, it will be premature to tighten fiscal policy further as RBI may have to readjust its priorities, depending on the way inflation and financial markets behave. It’s time for fiscal policy to take the lead as the services sector needs targeted assistance. For second-tier Indian firms, risk-averse banks are unlikely to make a meaningful difference. It’s government spending which can crowd-in private business and investments. The Union Budget needs to reflect this approach.