How globalization of inflation has driven Indian monetary policy

11 Jul 2022 , 12:06 PM

Today, high inflation is not only a challenge in India, but a much bigger challenge in developed countries like the US, UK and even in Europe. Speaking at the Kautilya Economic Conclave, the RBI governor, Shaktikanta Das, outlined how this phenomenon of inflation globalization had left a deep imprint on monetary policy. Of course, the reference is specific to India.

Inflation: It looks like the Seventies

Inflation in the last few months has been largely driven by supply side factors. In the aftermath of the COVID pandemic, the liquidity levers ensured that demand damage was minimal. On the contrary, when things started normalizing, there was a lot of revenge demand resulting in demand for most products and services far outstripping supply. The supply could not keep pace and we have seen that phenomenon in crude oil, industrial commodities and even in microchips or semi-conductors as they are better known.

At least, in the US, the inflation almost looks like the heady days of late 1970s and early 1980s when inflation was persistently above 7%. That is, of course, before the legendary Paul Volcker came down with an iron fist to tame inflation. Over the last 3 months, central banks including the Fed, Bank of England and the RBI have been persistently hardening rates to bring down inflation. As inflation continues to persist, it is now raising fears that the world economy may end up in recession or, at least, in Stagflation.

It is about globalization working both ways

Let me just spend a moment explaining this fact. Over the last 20 years, the forces of globalization have been largely responsible for controlling inflation. Consider these factors. Globalisation of trade and capital flows facilitated higher productivity and lower costs. The easy access to information, communication and transportation technology led to dispersed production hubs and enhanced the value chain. Above all, one of the outcomes of this globalization was competition, efficiency and innovation. This has been largely responsible for cutting costs in a big and enabling the addition of billions of dollars in economic value.

But, that was the more rosy side of inflation. In the last 20 years we saw labour, capital and technology getting globalized. What we are seeing in the last one year is inflation getting globalized. As OPEC raises oil prices, millions of people around the world are suffering from imported inflation. Similarly, as Indonesia and Australia made their coal pricier, it pushed scores of industries across the region to the verge of unviability. For example, the war in Europe has created one of the biggest inflation triggers and the stringent sanctions are not helping matters. Inflation is hitting currencies and that is, in turn, hitting inflation indirectly in numerous other countries. The story is; inflation has been the downside of globalization.

Just look at the number for confirmation. In the year 2021, nearly 77% of countries reported acceleration in inflation. By 2022, nearly 90% of countries in the world had started reporting acceleration in inflation. Prior to this new phenomenon, the median inflation in advanced economies was 2% and in emerging markets it was 3.5%. In the last few months, the inflation for advanced and emerging market economies is well above 7%. The inflation impact has been more pronounced on net importers like India, the US and the UK.

How globalization of inflation influenced monetary policy in India?

To an extent, the globalization of inflation left an imprint on Indian monetary and fiscal policy. For instance, between September 2016 and February 2020, CPI inflation in India was anchored at around 3.9%. It is only post the pandemic that India saw the full impact of globalization on Indian inflation, which is now well above 7%. If one looks at the 2 key recent events viz. the pandemic and the Russia-Ukraine war, here is how monetary policy in India has evolved as a response mechanism to the globalization of inflation.

a)      The sharp spike in globalized inflation has led to a smart improvement in the central bank’s communication. The communication of the RBI in the last couple of years has been largely focused on managing the expectations of households, analysts and market players. Ultimately, it is inflation expectations that sets the tone. This led to the time-based guidance of accommodative monetary policy. For investors who wondered as to why RBI was maintaining an accommodative tone, it was just part of a strategy to manage inflation expectations better.

b)      The second shift in communication is the release of MPC minutes after 14 days and the RBI governor himself directly communicating on the inflation expectations. This gives the forward looking statements more credibility. It is the first time that we have seen the RBI governor addressing the financial markets on multiple occasions rather than just restricting himself to the post policy meeting.

c)      RBI has placed a lot of emphasis on prudence in this environment. For example, the RBI G-SAP program made it one of the first central banks in the world to proactively taper the liquidity in the system. Fed started its taper much later. The RBI also sent a strong message of prudence when it refused to get its deficit monetized by printing of fresh notes or via devolvement of bond issues with the RBI. This has given out the right signal that the RBI would prioritize prudence in dealing with inflation.

d)      The other important message from the RBI was the focus on liquidity management. Most liquidity enhancement measures were introduced with a clear exit window and also staying ahead of the curve. For instance, RBI started rebalancing liquidity as early as January 2021 through the reintroduction of variable rate reverse repos (VRRR). This was instrumental in shifting liquidity from the overnight fixed rate window towards longer tenors at variable rates.

To sum it up, while most parts of the world enjoyed the fruits of globalization in the last 3 decades, we now get to see the downsides of globalization. That is happening through the swift transmission of inflation forces across the world. They create tough policy trade-offs, especially when the economy is just about recovering. The message from the RBI governor has been that while short term inflation may be outside our control, medium term inflation can be calibrated with the right policies. For that, RBI is leaving no stone unturned!