How Central Banks balance inflation and growth

2 Mar 2023 , 10:39 AM

These central banks need to ensure price stability. That means; prices cannot be allowed to spiral out of control. At the same time, these central banks must also ensure maximum employment. Normally, maximum employment is also used as a proxy for GDP growth since it is only when GDP growth is robust that jobs are created. In the last couple of years, this dilemma had largely reduced because growth continued to be robust, unemployment levels were very low but inflation was spiralling out of control. Hence central banks only had to focus on inflation. That is changing as countries are increasingly facing the ghost of weak consumer demand. Economists are apprehensive that there could be a full-fledged recession.

It is in this context that the recent lecture by Governor Philip Jefferson, member of the Federal Reserve Board of Governors, at Harvard University assumes significance. At the Harvard University, Governor Jefferson spoke at length about “Recent Inflation and the Dual Mandate”. While inflation is something that is almost palpable to everyone, from a policy standpoint it is the measurement of inflation and the appropriate policy response that really matters. After all, there is the dual mandate always lurking in the background.

Measuring inflation – The US experience

Normally, WPI inflation is not very useful in inflation policy responses and it is the consumer inflation that is of greater import. However, the idea of consumer inflation, itself, is nuanced. For instance, in the US, there are broadly two types of consumer inflation that is tracked. On the one hand, there is the consumer (CPI) inflation that is announced by the Bureau of Labour Statistics (BLS) in the second week of each month. However, what the Fed actually uses for its policy decisions is the PCE (Personal Consumption Expenditure) inflation. This PCE inflation is normally announced towards the end of each month. But, how exactly does the PCE inflation differ from the traditional consumer inflation (CPI). In PCE and CPI inflation, Fed looks separately at headline inflation and also at core inflation components.

Broadly, both the CPI inflation and the PCE inflation are similar in that they measure the change in the index of prices of a basket of goods against the base year. Positive changes in this index are recorded as inflation and in the US, there is importance given to YOY inflation and also to MOM inflation. The two indices differ in the weight assigned to specific items. PCE price index has a broader scope than the CPI. The CPI is limited to expenditures that households pay out of pocket, while the PCE also covers items like Medicaid provided to them. Housing is much bigger in CPI while medical services is much bigger in PCE. Also, PCE provides time-varying weights, while CPI provides static weights. Hence, policymakers find the PCE more reflective of inflation from a policy perspective. 

Why inflation has been the focus since 2021

One thing is clear, the Fed has veered towards inflation control in its policy focus. The reasons are not far to seek. The negative real GDP growth in the first two quarters of 2022 were largely driven by very high levels of inflation. In fact, if the inflation deflator was excluded, then the nominal rates of growth were attractive all through this period. That reinforced the Fed commitment to focus more on inflation control as the theme of central bank policy. The other aspect was employment. The unemployment rate in the US had fallen to 3.5%, which is almost 150 bps below what the Fed defines as full employment levels. As a result, the Fed had to be doubly focused on inflation so as to make rate hikes impactful after adjusting for the effect of strong labour data.

Advantages of focusing on 2% inflation in the US

There are several reasons why the Fed has focused hard on containing inflation to 2% levels or, at least, wait till inflation is on a sure shot journey towards 2%. 

1. It has been empirically proven that deviations from price stability in the form of persistently elevated inflation rates are costly for the economy. Most households and businesses have preferred stable and low levels of inflation over a longer time frame.

    

2. Key choices regarding work, savings, inventory accumulation and business expansion are much tougher to make when there is uncertainty about future course of prices. Even something as basic as retirement planning by households gets hit by high inflation.

    

3. High inflation also hits employees hard. For instance, the labour market normally sets future trajectory of nominal wages in advance. However, unanticipated bouts of inflation typically lead to a drop in real wages, and hit household budgets.

    

4. Inflation tends to become a tax in addition to the already existing tax burden. Also, most tax codes do not factor in inflation or they factor in normalized inflation. Hence the burden of taxation gets compounded in times of high inflation.

    

5. Finally, let us not forget that high inflation pushes up inflation expectations and that has normally been a key determinant of consumer behaviour and future inflation. It also tends to force irrational economic decisions among people.

 

Why the dual mandate assumes importance?

As Jefferson rightly pointed out in his speech, this dual mandate is especially relevant as it is all about Fed credibility. As long as the Fed is working on containing inflation, it keeps the consumers happy and confident that inflation would eventually come under control. That is why the hawkishness of the Fed is important. However, that is where the dual mandate come in. There are several indications that the US economy could eventually slip into recession and there are 3 such indications.

• Firstly, the consumer demand has been shrinking and that is evident in the global demand for a lot of products and services that are being exported to the US. Most exporters to the US, including India and rest of Asia, are feeling the pinch.

   

• Housing is where most of the pressure is being felt. The combination of reduced income prospects, weak growth and higher interest rates has badly hit the home purchases by the American households. That has been the most obvious manifestation.

   

• Lastly, the yield curve slope has been negative for some time now. A negative is defined by the negative spread of 2-year holds over 10-year yields on debt. That is now roughly -0.90%, the highest it has been in a long time; a sure sign of impending slowdown.

Here is where the Fed has to balance the dual mandate. After all, if inflation is bad then a recession is worse. That is something, the Fed can ill afford.

What are the takeaways for India?

In a sense, the Indian economy also finds itself in a similar situation. The RBI has been steadfast about containing inflation. However, the impact on growth has not been too visible, although the third quarter of FY23 did see real GDP growth dip to 4.4% and nominal GDP growth also dip to 10.8%. India has managed inflation control through monetary policy while it has managed to sustain growth through fiscal policy. The latest budget measures on putting more money in the hands of people and infrastructure spending are cases in point.

RBI believes, and rightly so, that persistently high inflation hurts everyone and hence the RBI is unlikely to relent on its anti-inflation stance. The 4% inflation target may still be quite far away and how India manages to contain inflation without hampering the GDP growth will be the litmus test.