For a context-based monetary policy

The continuous fall in inflation ever since inflation targeting was adopted has surprised many, including official forecasters. Our cautious policymakers, however, have been reluctant to believe the fall can be persistent, and have lagged in reducing interest rates.

Policy discussion tends to list demand and supply-side risks to inflation together. But as long as there are favourable supply-side developments, a rise in demand will not create inflation. In the Indian context, optimal response requires carefully distinguishing between factors that affect demand and those that affect supply. To the extent there is a persistent fall in costs, a demand stimulus need not be inflationary.

Food price inflation triggered India’s high inflation episode starting in 2007, but has remained moderate through four years of bad and good monsoons, indicating supply-side improvements. The current crash in prices suggests we can easily reach a position of glut, and policy has to gear up for that by improving processing facilities. Squeezing out intermediaries is the way to give farmers good returns even as prices remain low for consumers.

Despite its federal structure India never had one domestic market. This raised transaction costs of business. The Goods and Services Tax, implemented last month, already shows signs of reducing these costs.

More standard reforms are also taking place, with improvements in infrastructure, ease of doing business, better facilities, improved data collection and standardisation for micro, small and medium enterprises.

Despite OPECs efforts, it seems shale oil will cap the rise in international oil prices — a major cost saving for import-dependent India.

Better governance raises productivity and reduces costs of supply especially for those with low incomes since they are more dependent on public goods. As awareness and per capita incomes rise, vote banks are giving way to demand for public goods delivery through better governance. In recent State and Central elections the governance plank has won votes, ensuring steady action on this agenda.

An economy in transition should be one which is innovating, especially in ways that reduce costs, thus creating more inclusion. There are signs of this in India. A reason for slow global recovery is slowing productivity growth in advanced economies as well as Asia. Although the investment and trade slowdown behind this impacts India also, productivity continues to rise here.

Demographics are favourable; there are improvements in human capital and transfer of resources to more productive sectors. India does have a long way to go from its current levels of about 45 to reach the US frontier at 100, but with correct policy catch-up can be rapid. Much is happening in the digital space. New technologies that leverage youthful skills, and reduce prices to target low income masses, give a special advantage.

Change is difficult to measure in a period of flux. Recent revisions of India’s output and inflation indices illustrate the difficulty for policy that relies too much on data. Growth was higher and inflation rates lower in the new series. That data does not adequately capture change helps the conservative view to overlook the persistent fall in inflation. Revisions come from moving closer to international practices and shifting to larger databases, thus capturing the growing depth of the economy. Inflation may actually be over-estimated worldwide, since many free services the new economy provides, such as YouTube videos, escape measurement.

Fundamentals are improving and reducing costs. But instead of supporting demand in view of adequate supply-side change, policy fears any anticipated increase in demand and tightens against it. Demand-side factors flagged include fiscal deficits and pay commission awards.

It is true competitive demands for farm loan waivers are escalating from States. But hard budget constraints and better incentives imposed by fiscal responsibility legislation will prevent an explosion in State deficits. The pay commission award will only create demand in industries where capacity utilisation remains low. Since investment and exports continue to stagnate, consumption must be allowed to drive demand and then investment. A few positive demand shocks are not a risk. Core inflation that was always labelled as sticky has also fallen, suggesting there is no excess demand. Under low demand keeping the real interest rate above 2 per cent is a mistake.

Forecasts cannot be based purely on past data, especially at a time of structural change. Policy also cannot wait for and solely rely on new data, when the data itself is subject to revision.

Rather than simple time series methods, forecasts should be based on Bayesian statistical techniques that include theory yet allow these priors to be refined with new information. A theoretical framework is essential.

Systemic forecast errors suggest the underlying model of the economy must be rethought and fundamental changes identified. Different types of consistency checks can be used.

For example, if inflation does not rise even as output exceeds the expected potential, the potential must have risen. If inflation targeting is used flexibly as it should be, changes in potential can reveal themselves without being squeezed by excessive tightening, even as inflation expectations are anchored. Policy impacts have long lags in India because of a large share of backward-looking behaviour. So delays have large costs, and can also create instability.

Since forward-looking behaviour is limited large policy action is not required; more uncertainty also supports small and therefore fast response. But a small change works best as part of a string. It is useless with a neutral stance.

Delayed reaction, so that interest rates adjust to inflation only with long lags, creates other major risks. Firms’ debt burdens rise. Excessive foreign debt inflows appreciate the currency and further reduce demand.

The conservative belief is that pain today will squeeze out waste and make possible a better future. But excessive and unnecessary pain has hurt the present while the future remains elusive.

It follows from thinking about the macro economy in an incorrect framework. Context-based policy can reduce unutilised resources and output sacrifice today, even while building for the future.

The writer is a professor at the Indira Gandhi Institute of Development Research in Mumbai