Monetary policy, global and local
Business Standard, 12 June 2023
There was a sense that the US Fed was at the end of their journey, of getting the US CPI on its journey to the 2% target. This job has been complicated in recent weeks by a strong showing in the US economy, and by concerns about sustained exports from Ukraine. The US may now be headed for 50 bps more of rate hikes. Here in India, monetary policy actions by the US Fed and by RBI have significantly reined in the post-covid expansion. RBI's strategy of holding is on track.
In 2021, the US Fed started chasing a significant inflation problem in the US. They have hiked 10 times from March 2022 onwards and their short rate now stands between 5 and 5.25 per cent. Alongside this, Russia invaded Ukraine in February 2022. These two events created new pressures in the world economy.
The idea of inter-disciplinary thinking, to better comprehend an interconnected world, sometimes veers on cliche. But the events after 2022 were a fresh reminder that with 50 years of deepening globalisation behind us, we are now in a richly interconnected world. There are now a large array of consequences, all over the world, of these two forcing functions.
Tightening by the US Fed impacted upon illiquid and risky assets worldwide, which in India translated into a changed world for startups, crypto currency, the broad equity market and real estate. The invasion of Ukraine triggered off fundamental rearrangements in the global energy market. Europe, which was the most important customer of Russian oil and gas, turned away from this, and pushed through a remarkable expansion of renewable energy. With the European net-zero targeted in 2035, Russian gas will never find its way into the European market, except for the unlikely scenario of a rapid regime change in Moscow and a new democratic government. Russia needs to sell as much oil as possible in order to fund the war, and the West forced a $60/barrel price limit on these sales. More generally, fossil fuel producers have started feeling the heat of global decarbonisation, and there are incentives to produce more while you can. These issues have added up to a soft global energy price environment.
Monetary policy works by slowing down economic activity and obtaining reduced demand. For some time, there was a sense that the US Fed was at the end of its journey of tightening. But on 2nd June, there was a surprisingly strong employment data release in the US, with jobs growth of 0.339 million (seasonally adjusted) in May. Prime age labour force participation (i.e. for persons of age 24-54) rose to 83.4% which is quite tight. This suggests that the Fed needs to do more to crimp demand.
The war continues to create unpleasant surprises. The Kakhovka dam on the Dnipro river was under Russian control. It created a reservoir with 18 cubic kilometres of water (about twice that of the Gobind Sagar lake behind the Bhakra Nangal dam). The dam was blown up from the inside on 6th June. This creates flooding of a large area, and about 0.6 million hectares lost irrigation. Ukraine is an agricultural powerhouse. Their exports were already down by 40% owing to the war. The destruction of the dam further crimps their ability to export, and influences global food prices.
The destruction of the dam also impacts on manufacturing in that region, including one ArcelorMittal plant. This raises the scenario of a fresh spurt of supply difficulties in 2023, on a smaller scale when compared with the supply chain crisis of the post-covid recovery. Even if Ukraine fares very well in its first major counteroffensive, the lands that are retaken will not be restored to normal economic activity for many years, owing to the scale of the destruction, and owing to fear of future Russian attacks.
These difficulties have adversely impacted the US Fed's search for price stability. CPI inflation in the US has improved, but it remains at about 5 per cent, which is quite a distance from the inflation target of 2%. The recent data flow (including US inflation and production in Ukraine) has shifted views on what the US Fed will now need to do. The consensus now envisions them going up to between 5.5 and 6 per cent. No cuts are expected until 2024.
In India, the macroeconomic context is quite different. Monetary policy tightening by RBI and by the Fed has helped pull back the post-pandemic expansion. Many important indicators show slow growth in the latest year. Headline inflation has dropped greatly over the year, and stood at 4.7 per cent in the latest data (of April), which is only 70 bps above the target of 4 per cent. RBI's main strategy, of pausing after February 2023, is on track.
The inflation targeting system has worked well in reshaping the incentives of RBI. It requires RBI to forecast inflation 12 to 18 months out, show its homework in public, and respond to those forecasts today while engaging with three independents on the MPC. Surges of inflation have generated more rapid action by RBI than was the case prior to the onset of inflation targeting in 2015. Inflation targeting is symmetric, in that it also paves the way for rapid action by RBI as and when forecasted inflation droops below 4%. If the problems in Ukrainian food exports do not cause too much global food inflation, we may be in that scenario in coming months.
If the US Fed hikes and RBI does not, this will give some rupee depreciation. This will have valuable impacts upon the sluggish local economy. For domestic tradeables producers, INR depreciation lifts the top line when imported goods become a bit more expensive. For domestic exporters, products priced in INR become a bit cheaper when the INR depreciation. Both these channels of influence will help the local economy at a time when this is required.
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