Third Quarter Review of Monetary Policy 2009-2010
-28th January 2010
II. Outlook and Projections
31. While the baseline scenario is comforting, a number of downside risks to growth and upside risks to inflation need to be recognised.
(i) There is still uncertainty about the pace and shape of global recovery. There are concerns that it is too dependent on public spending and will unravel if governments around the world withdraw their fiscal stimuli prematurely. As the world discovered during the recent crisis, the global economy is heavily inter-linked through the business cycle. A downturn in global sentiment will affect not only our external sector but also our domestic investment.
(ii) Oil prices have been range-bound in the recent period. However, if the global recovery turns out to be stronger than expected, oil prices may increase sharply, driven both by prospects of demand recovery and the return of the investment motive, which will affect all commodities. This could stoke inflationary pressures even as growth remains below potential.
(iii) Expectations of softening domestic inflation are contingent on food prices moderating. This, in turn, depends significantly on the performance of the south-west monsoon in 2010. If rainfall is inadequate, high food prices will continue to intensify inflationary pressures.
(iv) So far, capital inflows have been absorbed by the current account deficit. However, sharp increase in capital inflows, above the absorptive capacity of the economy, may complicate exchange rate and monetary management.
(v) As growth accelerates and the output gap closes, excess liquidity, if allowed to persist, may exacerbate inflation expectations.
32. Beyond the above risk factors, by far a bigger risk to both short-term economic management and to medium-term economic prospects emanates from the large fiscal deficit. The counter-cyclical public finance measures taken by the government as part of the crisis management were necessary; indeed they were critical to maintaining demand when other drivers of demand had weakened. But as the recovery gains momentum, it is important that there is co-ordination in the fiscal and monetary exits. The reversal of monetary accommodation cannot be effective unless there is also a roll back of government borrowing. As indicated earlier (para 13), even as the government borrowing had increased abruptly during 2008-09 and 2009-10, it could be managed through a host of measures that bolstered liquidity. Those liquidity infusion options will not be available to the same extent next year. On top of that, there will be additional constraints. Inflation pressures will remain and private credit demand will be stronger with the threat of crowding out becoming quite real.
33. There are standard, well-known and well-founded reasons for fiscal consolidation. For both short-term economic management and medium-term fiscal sustainability reasons, it is imperative, therefore, that the government returns to a path of fiscal consolidation. The consolidation can begin with a phased roll back of the transitory components. Beyond that, in the interest of transparency and predictability, the government should ideally do two things: first, indicate a roadmap for fiscal consolidation; and second, spell out the broad contours of tax policies and expenditure compression that will define this roadmap.
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