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Return of Inflation: A New Policy Conundrum

Inflation is too much, isn't it? This article deals with the current dynamics of inflationary policy.

The Covid-19 recession hit the world economy hard, yet stock markets are on a roller coaster ride. The widening gap between the real economy and the financial markets has previously been warned against by regulatory bodies, economists, and seasoned investors. Since the outbreak of the epidemic, central banks' cheap money policies have resulted in a liquidity glut in the global financial system, with cheap credit flowing into stock markets and other asset classes. The annual rate of inflation in the United States increased to 5.4 percent in June, the highest monthly increase since 2008. The dovish central bank is having trouble keeping up with rising inflation. Despite rising inflation, the US Federal Reserve kept its benchmark interest rates near zero and chose to keep the $120 billion monthly asset purchase programme going. The Federal Reserve's Open Market Committee(FOMC), which sets monetary policy, has signalled two rate hikes by the end of 2023, but rising inflation may prompt the central bank to become more hawkish and tighten monetary policy. The spike in inflation, according to Federal Reserve Chair Jerome Powell, is a temporary phenomena, dismissing predictions of a repeat of the Great Inflation of the 1970s. According to him, the spike in consumer prices was caused by a comeback in consumer spending, rising gasoline prices, a recovery in the labour market, and supply restrictions to absorb the surge in demand following the economy's reopening.


Why does it matter?

The United States' economic policies have a substantial influence on other countries' policy decisions around the world. The return of inflation is haunting market participants and policymakers. All around the world, consumer prices are rising. The central banks responded by maintaining adequate liquidity in the banking sector to the extraordinary economic shock caused by the Covid-19 outbreak. Low interest rates are intended to reduce the cost of capital for firms, encouraging them to borrow and invest, while lower interest rates discourage people from saving, encouraging them to spend now. The return of inflation would force the central banks to slow the pace of its liquidity injections in order to keep inflation under control. The monetary authorities' cheap money policy fueled a boom in stock markets and Foreign Portfolio Investments(FII) to emerging market economies. The Nifty and Sensex have recovered 100 percent since their April 2020 lows and are now at all-time highs. Money flooded into financial assets as a result of the cheap money policy, inflating the asset prices.


How does it affect India?

Though the RBI restated its commitment to remain accommodative, it must develop its own solutions to deal with rising prices as a result of supply interruptions and cost-push pressures. Foreign Institutional Investors (FIIs) may flee emerging markets in pursuit of higher and safer returns if the US adopts a tighter monetary policy, putting downward pressure on the home country's exchange rate and causing the US Dollar to appreciate. The pace of economic recovery could be hampered by rising crude oil prices and a weakening rupee. In June, the Indian rupee fell by roughly 2% as market expectations for an early rate hike grew. The market is already concerned about a repeat of the "Taper Tantrum" [1], when the US Federal Reserve began policy normalisation in 2013. Any policy shift to combat rising inflation before the economy is back on track might cause a sell-off in financial markets, resulting in lower bond yields, rupee depreciation and capital outflow from India. In comparison to our predicament in 2013, the Indian economy is currently in a better position to fight such policy adjustments because of our record forex reserves. RBI can intervene in the forex market to lessen market volatility, thanks to its $600 billion forex reserves. At a time when the country's informal sector is in shambles, the country’s poor is worst affected by the rising inflation.

What lies ahead?

The US economy is currently ‘hot.' Prices in the used automobile and property markets in the United States are soaring, as are inflationary pressures in commodities durables. Since June 2020, the Federal Reserve has been buying $40 billion in mortgage-backed securities and $80 billion in Treasury debt as part of its asset purchase programme. To tame the inflationary trends in the economy, the Fed might trim its asset purchases to achieve its targeted inflation of 2%. The trillions of dollars of money printed by the Fed, according to the critics, is flowing into financial assets rather than influencing real output. Because of the rise in inflation, policymakers have less room to cut key policy rates in order to maintain a steady path for economic recovery. In 2021, no developed countries raised rates, but some countries, such as Russia and Mexico, did so to tackle inflation. If inflationary pressures do not subside over time, other central banks will follow suit. For the second month in a row, inflation has exceeded the RBI's targeted zone of 2-6%. Rising oil prices may boost inflation, leaving the RBI with less tools to maintain its growth-oriented monetary policy stance. Government intervention to reduce the excise duties and taxes of petroleum products could curb the price rise but would the central and state governments give up a large source of revenue in order to keep prices in check? If inflation is to remain stable, the RBI must abandon its dovish position? If the inflation is to stay the RBI has to give up its dovish stance. The return of inflation has now become a great concern for policy makers all around the world. In this policy dilemma, the governments and central banks have to carefully steer the economy by striking a balance between price stability and economic growth.

 

Footnotes

[1] Taper Tantrum- When the US central bank announced that it was slowly putting the brakes on its quantitative easing (QE) program, investors assumed that interest rates in the United States would rise. And when they realised they didn't need to stay invested in emerging economies any longer, they withdrew their money overnight, resulting in an unprecedented outflow of foreign funds. The domestic currencies (here Rupees) were exchanged for US dollars by investors. As a result, the value of Indian rupees quickly depreciated.

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J Vijay Kumar
J Vijay Kumar
Jul 24, 2021

Good article. Thanks

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