Distant thunder in the world economy

Business Standard, 1 June 2021

Here in India, we are recovering from the second wave, and peering into the recovery of the economy. Elsewhere in the world, the health problems are receding, and the economic recovery is proceeding strongly. In the US there are some concerns about inflation. In the short term, there is a fair chance that these are just the inevitable glitches that arise when switching the complex market economy back on. Once the restoration of normalcy is completed, the question of developed market (DM) inflation will become more pressing. When DM interest rates start rising, this will impinge on capital flows and asset prices in India, and present policy makers with a puzzle.

In Indian macroeconomics, things are looking difficult with household demand, government demand, and private investment demand. One bright spot is export demand. The world economy is recovering strongly, as prosperous countries were able to bring their high state capacity to bear on vaccination. In the US, a euphoric recovery has come about, through the reduction in the political influence of Trumpism, through vaccination, and through fiscal policy playing on a World War II scale.

Some inflationary indicators in the US suggest a rapid recovery of inflation. A debate is taking place in the US about the extent to which this poses a problem. For us in India also, as we come to the end of the second wave, and with the improved prospects on the health situation, we are curiously wondering how the economy will come back into high gear.

Some brief inflation may be an inevitable part of the reopening. In the modern market economy, there is no central planner. A government can use state power to force firms to close. But there is "hysteresis": the government cannot control how the economy comes back to life. Each firm and each individual makes economic decisions such as restoring operations at full scale and doing labour supply. These decisions are made in a decentralised way: Each economic agent thinks and acts alone, without co-ordination with others.

Coffee shops look at consumer demand alone and make decisions to reopen. No government tells people what to do, and there is no co-ordination of reopening between coffee shops and coffee bean producers. When the coffee shops reopen, the coffee bean producers may not be ready. The price of coffee beans will go up.

Reopening decisions are co-ordinated through the price system. Prices send out information that guides firms on how and when to come back to full-scale production. Output prices need to go up, firms need to feel that prospective profitability is good, that the fixed cost of switching on production is justified. Only then do firms decide it is time to step out of wait-and-see and hire to restart. Temporary inflation -- a slight overshooting of prices of goods and services to the point where production is rather attractive -- is one element of how the vast decentralised market economy comes back to life.

Such a phenomenon is not a problem for any modern central bank. All modern central banks have inflation targets phrased in a long-run fashion and are likely to see through brief patches of inflation. As an example, the Indian monetary policy committee (MPC) correctly saw through the odd inflation of 2020. Within a few months, this glitch of reopening will be finished. After that, the question about the US economy is: When faced with very expansionary fiscal and monetary policy, will significant inflation recur? If this happens, the US Fed will perhaps change course on communication by 2022 with actions in 2023.

Capital flows to emerging markets (EMs) are shaped by "push" and "pull" factors. "Push" factors are low-interest rates and low risk in DMs, which guide institutional investors in DMs to obtain the higher rates of return available in EMs albeit while bearing higher risk. "Pull" factors are the economics and politics of the EMs: The prospects for sustained growth and for low correlations with international portfolios.

For some in India, interconnection with the world has not been internalised. When foreign investors reward performance in India and punish failure, we complain of the loss of strategic autonomy, the freedom to underperform. When push factors send capital to India, we bask in the glory, but when push factors withdraw capital from India, we complain that globalisation is a bad thing. When the world economy is booming, we want to export into it, but when world trade stagnates, we complain about export dependence. Integrating into the world economy creates a new structure of inter-relationships. We need to embrace interconnection and behave like other mature market economies.

When the US Fed raises rates, this tends to reduce capital flows to EMs. Sometimes there are glitches. In 2013, the US Fed fared poorly in communicating its change in stance, which led to a global disruption that has been termed "the taper tantrum". In that period, the Reserve Bank of India (RBI) did not have an inflation target, and it chose to target the rupee, it raised the short rate by 400 bps in order to make capital inflow more attractive for foreign investors, and thus prop up the rupee. This had an adverse impact on the economy.

We're still in the happy period of the global economy coming back to life, and an export boom for India. But there is distant thunder in the world economy that merits attention. We in India need to watch carefully and develop a point of view on five questions:

  1. By late 2021, what will the inflationary situation in the US look like?
  2. Will the US Fed start getting concerned about the resurgence of inflation?
  3. Will they successfully manage their communication strategy, when the time comes to change course, thus avoiding the problems of the taper tantrum?
  4. When the outlook for DM inflation and interest rates changes, how will this impact asset prices and capital flows into India?
  5. And finally, how will the RBI stay focused on its inflation target through these events?

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