Times of Inflation - Part 2
It's been a year since central banks around the world started their rate hikes cycles. Some are still continuing with hikes (ECB, BoE etc), some have now hit pause like US Fed & some paused sooner like India RBI, and continue to hold the rates. Building on last year's article, let's look at how things position today after rate hikes, changes in global economic & geopolitical factors and policies adopted for managing inflation. I also give a perspective on India's inflation problem and insight on why rate hikes are inappropriate tools for managing inflation. India has been reeling under elevated inflation in post pandemic times just like most other parts of world. India's policy response by government and central bank has dissimilarities with policies of 2010-2011 when it faced inflation problem under the previous government.
What caused inflation?
What caused inflation? - This is a complex topic with variety of opinions by various experts. Some attribute it to overheated economy because of excessive fiscal spending & altering of spending patterns in peculiar ways, diverting from services towards goods (demand pull inflation), others attribute it to supply chain disruptions induced by pandemic lockdowns & Ukraine war (cost pull inflation), but mostly experts attribute combination of both factors as the cause. There are other theories on inflation like seller's-inflation. This is based on assertion that suppliers exploit opportunities from supply-chain disruptions and other factors for price gouging to maximize profits. This theory is also based on somewhat inelastic nature of demand during pandemic period. The supply side shocks caused firms to hike prices but the demand for goods was undeterred because of pandemic relief fiscal measures that gave extra spending power to households. The firms then saw an opportunity to expand their profit margins further as sales continue to materialize at elevated prices.
It's difficult to accurately quantify the contribution of all these factors in overall inflation. But the situation is getting better. With pandemic in rear view mirror, the global economy is now normalizing (1, 2). Various governments and firms are streamlining & investing in supply chains & production that will give long term benefits to global economy. The global energy prices have come down. To curtail overall demand, the central banks also used their blunt instrument of rate hikes which also made an impact. Inflation is in downward trajectory in US though it still remains unusually elevated in some countries like UK (Brexit a factor?). The fear of wage-price spiral & repeat of 1970s never materialized. Some experts predicted stagflation which also did not happen in US. There were theories on need to raise unemployment to solve inflation problem but inflation came down without increasing unemployment (1, 2).
There was uncertainty on energy prices in early days of Ukraine war which is now attenuated due to several factors. The western sanctions on Russian Oil did not cut-off Russian oil from global markets but diverted it to India & China and even back to western countries itself. The $60 price cap on Russian oil trade made Russian oil actually cheaper as Russia is desperately selling oil even at low prices to fund its war effort in Ukraine. US is now actively using SPR to keep a handle on present & future oil price spikes. Germany & other European states used partial price controls through subsidies to tame gas prices.
The dynamics of rate hikes curtailing demand is also not so simple. The present investment surge in US (due to IRA, Infrastructure bill, Chips act) is lead by construction boom related to manufacturing of renewable energy stuff (solar, wind tech, batteries, semiconductors etc). The newly adopted industrial policy has long term prospects, thus investors in that field are undeterred by high borrowing rates. The industrial policy is also a kind of bipartisan consensus (countering Make in China 2025 plan) which has given certainty to future of investment. So the connection between {interest rates-economic activity-demand-inflation} is not hard and fast rule.
What causes inflation in India?
The above mentioned factors cause inflation but there are some additional problems in India. The supply chains of Indian economy are rather weak compared to developed countries due to unorganized & backward nature of economy (poor infrastructure, poor market outreach, lack of cold storage chains - that specifically affect perishable food products etc). There is also a problem with lack of infrastructure of water irrigation which makes India's agriculture production heavily dependent on monsoons. The lack of flood control infrastructure is also a major problem which cause billions of losses of farm produce apart from other kinds of damages to life & property. These problems in India's farm sector have now aggravated by Climate change which has made monsoons more erratic and creating uncertainty.
Food price inflation (which is big chunk of inflation index) in India is related to monsoons (wonk stuff). Often, nonseasonal rains and/or floods leads to temporary spike in prices. To give a present example - The tomatoes (a perishable food staple) doubled in prices in just a week. In a country like India, supply factors are often significant cause of inflation. The problems greatly aggravates if multiple factors combine - Bad monsoons persistent droughts, nonseasonal rains & floods that destroys crops & disrupt supply chains, exogenous shocks like rise in global commodity prices (India imports nearly 80% of its oil) - when these factors combine, they lead to higher general inflation. What sense does it make to address India's inflation problem with rate hikes? The rate hikes are blunt tool to curtail demand and there is a lag period for rate hikes to make an actual impact on demand (& remember that inflation we are talking about is supply side). By the time, rate hikes starts to make a dent on demand, the supply problems might possibly resolve on their own (stabilization of global crude prices, normalizing of monsoons etc).
To counter inflation, India's central bank (RBI) followed footsteps of western central banks in hiking interest rates. The rate hikes followed US federal reserve & other CBs but decoupled from them later as RBI finally halted hikes in Fed 2023 (while continuing to monitor situation). Indian central bank has been judicious in rate hikes in contrast to previous rate hike cycle of 2010-11. India's last rate hike came in Feb 2023 with 25 bps & rates are on hold since then. Another thing worth noting is that India's current central bank policy is different from past policies under liberal economists. Earlier central bank policy was governed by economists like D Subbarao, Raghuram Rajan (former governors of RBI) who used interest rates manipulations more actively in managing inflation.
India's past policy on inflation control during 2010-11 - Why rate hikes are not the best tools?
India's previous experience in 2010-11 with inflation generated textbook response from central bank, aggressive rate hikes by doubling repo rate within a year. But this was contrary to approach of western central banks that left the interest rates unchanged during that period. The post GFC era involved unconventional monetary approach by western central banks, specifically the US federal reserve by adopting ZIRP (zero interest rates policy) and QEs (various rounds of quantitative easing). Some experts predicted these policies to cause inflation in long & medium term but that never happened. Inflation in India around 2010-11 was significantly induced by supply side factors, exogenous shock that made little sense to be tackled by rate hikes (1, 2, 3).
Another thing to note about India is that it's very different monetary economy from developed nations. India's monetary transactions overwhelmingly happen in hard currency (cash) and much of the economy is not hardwired to formal credit system (1, 2, 3). Some data on India's credit situation with household debt and credit cards. India's household debt (consumer loan and mortgages) account for around 15% of nominal GDP in contrast to US where household debt account for nearly 65% of GDP. Credit card penetration in India, presently only 5%, is far below most developed nations (like US with 65%) & even several developing nations.
It's a contentious issue among experts in developed nations about efficacy of interest rate monetary policy of managing inflation. Interest rates are indirect approach to managing inflation, which are often randomly (senselessly) applied even when problems may be supply side. But interest rate monetary policy makes even lesser sense in a country like India which overwhelmingly runs on hard currency. High interest rates may eventually bring down demand (hence possibly reducing inflation) but the lag period will be longer as monetary policy penetrates its way through India's complex system. By the time the interest rate policy start to make impact, it's possible that inflation may come down on its own (if supply side factors change).
There's a lag associated with monetary policy in impacting demand. Central bank changing interest rates do not alter the dynamics of demand overnight and in a country like India, the lag period is possibly longer. The end result is that interest rate policy, meant to target inflation, end up hurting economic growth. The organized sectors of economy (like core industrial sectors - hardwired to bank credit system) are the first to feel the pinch of higher borrowing costs whereas rural unorganized sectors (60% - 70% of population) feel the trickle down impact much later. These imbalances in India's economy make interest rate policy less effective in achieving desired goals.
Unintended consequences of monetary policy
Monetary policy which is a preferred tool for inflation management can also have unintended and unanticipated consequences especially when the rates are raised rapidly. In US, the collapse of Silicon valley bank & several others was the result. US is now seeing more mergers in banks & further consolidation. The complexity of today's financial system makes it difficult to anticipate all future scenarios and especially the deregulated areas are the first casualties of consequences. In India, the rapid hiking of interest rates in 2010-11 deteriorated the bank balance sheets and jacked up bad loans down the road. This was aggravated by failing of infrastructure projects especially the PPP ones which were ill-conceived and poorly managed. RBI rate hikes along with several other factors were the factors that derailed India's growth story in last decade.
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