For India, fiscal consolidation should not be only about growth but spending prudence should also be adhered to
Published Date – 11:45 PM, Mon – 7 August 23
By Anitha Rangan
The recent US sovereign rating downgrade by Fitch from AAA to AA+ may have impacted asset classes across the world, but the key underlying reason for the downgrade viz, high leverage and expansionary fiscal policies may have far more overarching implications. It could perhaps be the cause of sticky last mile inflation, which is proving hard to inch towards the ultimate 2% goal.
Much has been said about supply-side imbalances from the aftermath of the pandemic and geopolitics which triggered the historically high inflation levels. The resulting correction in supply-side shocks has indeed led to softening global inflation, especially in the US. However, little is being said about the expansionary fiscal and monetary policies and its resultant impact, especially on inflation. If it was only about supply-side imbalances, once largely corrected, it should have brought inflation closer to the historic 2% target. Why did that not happen? Maybe the answer is in the fiscal stimulus of the US government supported by quantitative easing (QE) of the Fed.
When governments spend excessively, especially on welfare schemes, without having commensurate revenue or potential for revenue in future, it is in the nature of expansionary fiscal policies. Expansionary fiscal policies are undertaken by governments by borrowing. The creditors can be financial and non-financial institutions, asset managers, other country’s government or the central bank itself.
On the other hand, quantitative easing (QE) is when central banks expand their balance sheet by buying securities (government securities or other securities), and, in turn, printing money and increasing the supply of money in the economy. QE is usually in times of economic distress. During QE, the balance sheets of central banks expand beyond their normal growth.
Tale of two QEs
Fiscal stimulus and monetary stimulus have not been flagged as a cause of inflation perhaps because the US has done similar stimulus in 2008. And that did not prove to be inflationary. Then why did we see inflation after 2020 QE (beyond easing of supply-side shortages)? The answer to that is both in the scale and construct.
The QE of 2008-14 was largely led by Fed buying distressed assets from banks viz, Mortgage-Backed Securities, providing liquidity swaps globally to avert a financial crisis and provide liquidity to the financial system (not just limited to the US).
In comparison, in the QE of 2020-22, Fed was buying US public debt, in effect, funding the US government for its expansionary fiscal policies (income and social security support) creating money in the hands of consumers. This is perhaps the reason why demand and wages in the US remained steady despite high inflation. This money, eventually, finding its way into the banking system as deposits has also been among the causes of asset-liability mismatch of the US banks.
In scale, public debt increased by $7 trillion and $7.5 trillion in each of the episodes – the first episode lasted for six years while 2020 lasted for two years. Alongside, the Fed’s balance sheet has also expanded sharply. In the first QE, the expansion was $3.5 trillion or 3.8 times while in the second, it was $4.7 trillion 2.1 times. However, the duration of the second QE being shorter, the impact on inflation, therefore, has been notably sharper.
Another key element of distinction is the starting point. The debt levels in 2007 were 35% which rose to 74% by 2014. With already higher levels of debt, public debt to GDP further increased from 79% to 97% between 2019 and 2022. The S&P downgraded the US rating from AAA to AA+ in Aug 2011.
Social Security, Income Support
One of the drivers of US services inflation viz, sticky wages and low unemployment is perhaps the aftermath of the income support (via money to the public). In the 2008 episode, social security or income security spends did not witness any increase. In comparison to subsidy in cash, subsidy in kind are not as inflationary. India for example distributed food and vaccines for free.
The spending of the “unearned income” of the QE of 2020 is likely driving the sticky last mile inflation. Therefore, the solution with the Fed is to break that demand by raising rates. And Fed will do until they see a slowdown in demand.
But is it that easy? The answer is No. Because the US continues to pursue expansionary fiscal policies. Public debt to GDP, at 97% in 2023, is expected to move to 119% by 2033. As per the budget statement of 2023, the US fiscal deficit to GDP is expected to remain 5.7-5.9% for the next 10-20 years. In comparison, the pre-pandemic level was 4.7% which in itself was the highest since 2009. Mandatory spending as a percentage of GDP is to rise to 15% by 2033, higher than pre-pandemic levels of 13%.
Net interest to GDP is expected to more than double from 1.6% in 2020 to 3.7% by 2033. The interest cost assumptions are guided by average interest rates of 2.7% for 2023 rising to 3.3% by 2033. If the assumptions are put to test, with $32 trillion of debt (& rising) even a 0.5% increase in interest cost is ~$500 billion or one-third of the 2023 fiscal deficit of $1.5 trillion.
Policy Divergence
In the past, both monetary and fiscal policies turned restrictive after an expansionary phase. Assessment of leveraging and deleveraging episodes of the US since 1962 indicates that each of the leveraging/recessionary phases has been followed with a deleveraging phase. The period of 1981-83 and 1991 leveraging periods were followed by a deleveraging phase. Public debt-to-GDP which rose to 48% in 1992 declined to 32% in 2001 and was only 35% in 2007. From 2014-2019 public debt-to-GDP levels rose from 74% to 79% (a moderate increase), However, from 2023 to 2033, the ratio is expected to worsen to 119%. The overall debt-to-GDP ratio from the current level of 125% could, therefore, go up 150%. This is predominantly driven by the fact that fiscal policies, which saw a moderation in periods following recession and stimulus, are not moderating this time.
The divergence between fiscal and monetary policies could, therefore, make Fed’s task harder and drive it to keep rates elevated for longer. In sum, Fed’s battle against inflation could be elongated by expansionary fiscal policies. The global rate environment could therefore remain “higher for longer”.
Lessons for India
Higher policy rates by the Fed are likely to impact the overall policy rate environment for India. However, lessons, more from the fiscal front, cannot be ignored. While India also had to provide stimulus during the pandemic, it was largely limited to food subsidy (in kind) and credit subsidy with RBI having done some heavy lifting in terms of rates (lowering of policy rate) and liquidity support.
While in India’s context, limited fiscal space in hindsight has proved to be a blessing in disguise, the country’s spending patterns on the revenue front, especially towards subsidies (food, fertilizer, rural employment), cannot be curtailed. Along with that is a rising interest cost. Salaries and pension costs are mandatory and will only rise with inflation.
Growth support is positive for India to moderate the leverage levels, but fiscal consolidation should not be only about growth. Spending prudence should also be adhered to. From 5.9% currently, the path to 4.5% by FY26 is a challenging task. The 3% FRBM target is “miles to go before I sleep”. Nevertheless, the commitment to a downward glide path along with the heavy lifting on capex is encouraging.
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