Financial markets have been rocked in recent weeks, as several central banks are belated to douse the flames of inflation in their respective countries.
The cost of living is increasing rapidly around the world. However, the extent of the problem is not the same in all countries. The spread of price pressures should be viewed not only in terms of headline numbers, but also the distance of the latest inflation readings from official or implied inflation targets in those economies. Inflation in major Western economies such as the US, UK, Germany, Spain, Canada and Belgium has gone too far from the target. Many Asian countries actually have lower inflation than the former group now – for example, Japan, Indonesia, Malaysia, the Philippines, South Korea and Taiwan.
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The latest monthly inflation numbers in India as well as Thailand are higher by regional standards, but still lower than in many affluent countries. The third group includes countries that suffer from widespread economic fears anyway: Turkey, Argentina, Brazil and Pakistan. Their inflation is well above the global average. And then there is China, where inflation is still not a problem, perhaps because strict lockdowns have artificially suppressed domestic demand in that country.
These varied inflation patterns mean that the coordination of global monetary policy will likely come under stress, as central banks normalize policy at various speeds. Normalization includes both higher interest rates as well as the withdrawal of excess liquidity from financial systems. The severity of monetary tightening will depend on the balance of two factors. First, countries where inflation is now well ahead of inflation targets will have to move faster. Second, countries where central banks have strong credibility may shy away from a modest response compared to countries where there is less trust in central banks.
The Reserve Bank of India (RBI) started the year with a relatively optimistic outlook on inflation. It has since moved rapidly, increasing its core policy rate by 90 basis points since early May. Further rate hikes are now expected during the rest of the year. The repo rate is still 170 basis points lower than the expected average inflation for the current fiscal.
Another way to estimate the end point of ongoing monetary tightening in India is through three sets of variables.
First, a neutral interest rate that can keep economic growth close to its potential while keeping inflation close to the target. Second, how the central bank estimates the difference between actual growth and potential growth on the one hand and expected inflation and its inflation target on the other. Third, it gives weight to the output gap and the inflation gap while deciding interest rate policy.
However, interest rate policy is not everything. Like its peers in other countries, RBI also has to manage its balance sheet. A recent note from the US Fed shows that a permanent reduction in the Fed’s 10-year US government securities equivalent to 1% of nominal GDP increases the term premium of a government security of similar maturity by 10 basis points. This means that monetary tightening must be viewed in terms of both the value of money as well as the size of a central bank’s balance sheet.
In this context the balance sheet of RBI can be seen. The chart here shows the trend in the size of RBI’s balance sheet as a percentage of nominal gross domestic product (GDP) over the past 25 years. The fiscal year 1997-98 is off to a good start, as it was the year when the RBI was relieved of the need to automatically fund the Centre’s fiscal deficit, a change that was later strengthened in the Fiscal Responsibility and Budget Management Act of 2003. it was done.
The data shows that, apart from the external year for the financial year 1997-98, the size of the RBI’s balance sheet has been between 19.43% and 29.09% of nominal GDP. The numbers came close to the upper end of the range in 2020-21 for three reasons: RBI bought dollars being pumped into India at the time, it increased its holdings of government securities through open market operations to support the government . Lending programs at low interest rates, and the pandemic itself led to a slump in nominal GDP.
RBI’s balance sheet has shrunk 3.3 trillion or 1.4% of nominal GDP from October 2021. Much of this shortfall is driven by the recent loss of foreign exchange reserves, although the rupee’s depreciation has helped soften the impact on the central bank’s balance sheet in terms of the Indian currency. , A smaller balance sheet, both in absolute numbers as well as in proportion to nominal GDP, will affect liquidity in the domestic financial system, although there are other drivers such as currency in circulation and government cash balances with the central bank.
In its recent report on currency and finance, the RBI estimates liquidity surplus inflation of over 1.52% of net time and demand deposits; And that a 1 percentage point exogenous increase in liquidity could push inflation up by 60 basis points a year. Result: The trajectory of the repo rate as well as the way the RBI manages its balance sheet will have to be looked at as the fight against inflation intensifies.
Niranjan Rajadhyaksha is CEO and Senior Fellow at Earth India Research Advisors and a member of the Academic Advisory Board of the Meghnad Desai Academy of Economics.