Rate hikes: Central banks are playing catch up 

Barendra Kumar Bhoi | Updated on: Jun 12, 2022
RBI: Balancing the growth-inflation conundrum

RBI: Balancing the growth-inflation conundrum | Photo Credit: SHASHANK PARADE

Central banks world over failed to recognise the inflationary signals. The result is the threat of stagflation

The global economy seems to be heading towards 1970s-type stagflation. Inflationary expectations are unhinged in most parts of the world. Similar to the mid-1970s, the supply shock has been the major reason for the current global inflation, evidently supported by ultra-accommodative monetary policy.

Growth momentum has weakened across countries. The IMF in its WEO, released in April, has pruned the world output growth to 3.6 per cent each in 2022 and 2023 from 6.1 per cent in 2021. While growth is facing multiple headwinds such as high and elevated commodity prices, especially of crude oil, prolonged conflict between Russia and Ukraine, and a possible sovereign debt crisis ahead, further growth deceleration looks imminent due to aggressive rate hikes by systemically important central banks.

Why are central banks so aggressive in a situation where growth is slowing? Have they been behind the curve for a while and therefore aggressive in raising the policy rates now?

There was a legacy issue of liquidity overhang for a pretty long period in the aftermath of the global financial crisis (GFC). Although normalisation of monetary policy was underway before the Covid pandemic, it was incomplete. The balance sheet size of major central banks was pretty large.

The Fed Reserve balance sheet, which was less than $1 trillion before the GFC, remained stubbornly above $4 trillion till December 2019 when the Covid crisis emerged. To support growth, adequate policy space was not created to deal with another crisis.

Central banks loosened their purse strings in the wake of the Covid pandemic as it was an unprecedented health disaster. The balance sheet size of the Fed Reserve alone more than doubled to about $9 trillion in a span of two years.

While central bank support was inevitable during the Covid crisis, delays in taking policy decisions in normalising monetary policy led to inflationary pressures spinning out of control almost everywhere. Central banks seem to have misjudged the inflationary pressures as transitory, arising out of Covid-related supply shocks.

In hindsight, one can argue that central banks failed to create enough policy space well before the Covid crisis. The same mistake was also committed again in the post-Covid period by tolerating/dismissing inflation as transitory. They were evidently behind the curve for a while. Hence, aggressive rate hikes are needed now to contain inflationary pressures in most countries. The most probable outcome would be stagflation down the line. Moreover, an increase in the sovereign yield would pose a severe debt servicing problem globally.

Indian experience

As India’s growth slowdown was very much in evidence since 2017-18, much before the Covid crisis struck, the RBI pursued an accommodative monetary policy since February 2019. In the wake of the Covid crisis, the RBI began firing from all cylinders to support growth. Monetary policy became ultra-accommodative, besides regulatory and liquidity management policy going a step ahead to supplement monetary policy initiatives.

For quite a long period, the short-term rates were well below the reverse repo rate. Conventional monetary policy was combined with unconventional measures, which flooded the financial market with unprecedented excess liquidity, sometimes exceeding ₹9 trillion.

Similar to many systemically important central banks, the RBI interpreted CPI inflation as temporary due to supply shocks even if it was above the tolerable limit of 6 per cent in 2020-21.

In 2021-22, India’s average CPI inflation was slightly below the maximum tolerable limit. The Russia-Ukraine war and concomitant rise in global crude oil prices changed the situation dramatically, supplemented by the rise in pent-up demand, both domestic and global.

Currently, India faces generalised inflation due to both external and domestic factors. The 7.8 per cent CPI inflation in April was a wake-up call for the Monetary Policy Committee to have an off-cycle 40-bps repo rate hike in May, a 50-bps increase in CRR, followed by another 50-bps repo rate hike in June.

It will take a while for the real policy rate to be positive unless the RBI raises the policy rate aggressively. To curb inflationary expectations, can RBI wait till the real policy rate becomes positive to announce the change in the stance of monetary policy to neutral or tight?

The current monetary policy stance is ambivalent – neither accommodative nor neutral — as it focuses on a calibrated withdrawal of accommodation. As the daily excess liquidity is currently above ₹7 trillion, it is unlikely to achieve quickly a net liquidity deficit, which is a desirable condition of liquidity management, at least in a tightening phase of monetary policy.

Draining out excess liquidity, advocated earlier, could not be pursued then due to its likely impact on the sovereign yield. Time has run out for the RBI to be nimble-footed in containing inflation.

The writer is RBI Chair Professor, Utkal University, and former Principal Adviser and Head of the Monetary Policy Department of RBI

Published on June 12, 2022
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