Inflation versus growth: How central banks will handle?

22 Apr 2022 , 09:57 AM

Speaking at the IMF 2022 Spring Meet, the Fed Chairman Jerome Powell invoked none other than Paul Volcker, the legendary Fed chairman since the late 1970s. The seventies were a tumultuous period for the US with the oil crisis followed by geopolitical risk across the Middle East. This had led to a massive spike in sticky inflation, akin to what the US economy is having today. That is why the decision of Powell to bring back memories of Paul Volcker is significant, at this juncture.

Will Powell follow the Volcker Rule?

If you read the US inflation script in the last few days, one thing is clear that, month after month, the reference is to the early 1980, more than 40 years ago. That was the last time that the US economy saw runaway inflation. It is also significant that this was the period that Paul Volcker adopted one of the tightest monetary policies, which set the tone of monetary policy for years to come.

Invoking memories of Paul Volcker, Powell reminded the audience at the IMF Spring Meet that Paul Volcker had to face two principal challenges in the early 1980s as the chairperson of the Federal Reserve. Firstly, he had to slay, what is now famously known as the “Inflation Dragon”.

Secondly, Volcker had to also eliminate the public belief that  high inflation was a fact of life. Volcker had to underline that inflation could be managed with appropriate policy changes. Since then, not only has US inflation been in check for over 40 years, but managing inflation expectations has become a key pillar of monetary policy; in the US and across the world.

Powell unambiguous about 50 bps hike in May-22

Behind the Volcker analogy was the unambiguous intent of the US Fed to go after inflation aggressively. Speaking at the IMF Spring Meet, Powell underlined that the Fed would raise rates by 50 basis points in the May-22 Fed meet with a few more possible instances of higher than 25 bps rate hike during the year 2022. That could mean Fed rates touching a level of 2.50% to 2.75% by end of 2022. That is already reflected in the Fed Fund futures expectation captured by the Fed MarketWatch.

If the Fed hikes policy rates by 50 bps in its May-22 meeting, there will be several events happening after a long gap. For instance, it will mark the first instance since 2006 when the Federal Reserve increased its policy rate at back-to-back meetings. It may be recollected that the Fed had raised rates by 25 bps in Mar-22. In addition, a 50 bps rate hike would be the first such increase since it was last undertaken in the year 2000.

The other important point made by Jerome Powell was on the amplification of the rate hike. In the Mar-22 meeting, the Fed had spoken about starting the unwinding of the Fed bond book of $9 trillion from May-22. At the IMF Spring Meet, Powell confirmed that portfolio shrinkage would commence in May to make it a double-barrelled effort to remove stimulus and curb price pressures. Fed has already indicated monthly shrinkage of $95 billion. CME Fedwatch is building in 50 bps rate hike in the 04th May FOMC meet and 15th June meet.

Justifying the aggressive implementation of rate hikes and liquidity shrinkage, Powell has warned about the lateral risk of supply-demand imbalances in the US labour market. US economists are worried this imbalance is already resulting in higher wages and inflation which could feed on each other. To justify his rate hike decision, Powell pointed out how unemployment had fallen from 5.6% in Jun-21 to 3.6% in Mar-22. That is better than full employment. In short, the US has rampant consumer inflation, high wage inflation, reasonable consumption led growth and near-zero unemployment levels. That is the perfect recipe for the US Fed to shift gears.

Europe is not buying the tightening story

In the past, monetary policy has generally been synchronized. For the first time, we have a situation wherein the EU is not in sync with the US and UK on inflation management. That explains why the European Central Bank (ECB) has kept rates close to 0% despite inflation going up to 7.5%. Christian Lagarde warned that too much hawkishness could result in a hard landing; something global economies were not prepared for. For Europe it was a choice between a hard landing and monetary divergence; choice between Scylla and Charybdis.

For Europe, the pitch has been queered by the Russia-Ukraine war. If you go by the IMF projections, they have already downsized global GDP growth by 80 bps to 3.6% for 2022. Unfortunately, bulk of this slowdown will be borne by EU nations, apart from -8.5% GDP contraction in Russia. Europe has high dependence on Russia for oil & gas needs, trade and movement of capital. Hence EU is sceptical about an ultra-hawkish policy at this point.

Emerging markets story and India story more convoluted

According to the recent IMF projections, much of the growth contraction due to the supply chain bottlenecks will be borne by the EMs. Also, high commodity prices will only benefit the commodity exporters and they are a minority in the emerging market universe. Countries like India import up to 85% of daily crude needs and commodity prices and supply chain bottlenecks are extracting a steep price. Most EMs have steep debt levels post-COVID.

India faces a different type of challenge. It needs to control inflation, but also needs to keep interest rates in check to curb government borrowing costs. With fiscal deficit to remain well above FRBM limits till 2026, India does not have too much choice. The good news is that Christian Lagarde of the ECB refused to endorse the possibility of rate hikes. While ECB would be data driven, Europe would not want to raise rates amidst the war.

For now that could be a saving grace for India. Monetary divergence is not something the US would also risk beyond a point. Yes, the Fed has spoken in extremely hawkish tones, but as we have often seen in monetary policy; there is many a rethink between the cup and the lip.