There was a surge in worldwide inflation in 2022 reminiscent of the 1970s. This came as a shock because inflation had faded from public memory following a prolonged period of price stability, particularly in advanced economies (AEs).
High inflation reduces economic growth; creates uncertainty in the financial market; retards investment; and worsens poverty. The context of the current inflation surge, subsequent policy response, and the likely outlook is important in this context.
To mitigate the adverse impact of recent crises (2008 financial crisis, Covid pandemic, Russia-Ukraine war), central banks around the world responded with unprecedented force. The Federal Reserve (Fed) in the US responded to the global financial crisis of 2008 by rapidly lowering the Fed funds rate and concurrently expanded its balance sheet. Other central banks, followed suit. Policy interest rates came down to historic low levels and the global economy was awash with liquidity. There was a belief that if output remained within its potential level, such policies were unlikely to engender inflation.
As the global economy showed signs of recovery central banks contemplated normalising their monetary policy. The Fed’s attempt in 2013 met with severe adverse reaction by the financial markets — popularly known as the ‘taper tantrum’. Central banks having backed themselves to a spot found it difficult to reverse gears. Since inflation was not an issue, a loose monetary policy was tolerated for far too long.
Then the world was hit by the Covid 19 pandemic. Central banks responded with the same playbook of easy monetary policy as economic activity stalled. As people lost their livelihoods, governments put money in people’s hands through various relief measures enlarging deficit and debt. The pandemic exposed how global production and supply was skewed toward China! These developments coupled with spikes in energy and food prices sparked worldwide inflation. Central banks around the world have shown the resolve to tighten monetary policy.
The Fed has lifted its policy rate rapidly. As the Fed tightens, the US dollar flows retract disrupting financial markets. Other central banks are made to raise their interest rates to stem capital outflow and stabilise exchange rate. India too experienced substantial capital outflow and significant exchange rate depreciation. In response to the elevated inflation rate, the RBI raised its policy repo rate to 6.25 per by December 2022.
Economic implications
First, headline, aggregate consumer price, inflation looks to have peaked, barring unexpected large shocks; but core, consumer price excluding food and energy, inflation remains elevated. This suggests that inflation has generalised.
A few more increases in policy rate by major central banks are not unlikely, at least policy rates will remain high for some more time. Consequently, the economy has to contend with a higher interest rate regime coupled with tighter liquidity.
Second, market interest rates will remain high in response to higher policy rate — raising borrowing costs, impacting asset valuation, and moderating demand for interest-sensitive sectors.
Third, financial markets could experience occasional volatility, particularly if the Fed policy rate calibration runs counter to market expectations. This has adverse effect on EMEs like us as capital flows become volatile.
Fourth, higher interest rates will dampen global growth, maybe tipping a few AEs into recession.
Finally, for India, GDP growth estimated at 7.0 per cent in 2022-23, was the fastest among large economies in the world. Going into 2023-24, domestic drivers of growth have picked up, the latest being corporate Capex intent; but net exports will be a drag clouding our growth outlook. Curbing market volatility and enhancing export competitiveness will be vital.
The writer is Chief Economic Advisor, FICCI, and former ED, RBI