The global economy appears to be headed for 1970s-style stagflation. Inflation expectations are out of balance in most parts of the world. As in the mid-1970s, the supply shock has been the main reason for the current global inflation, obviously supported by an ultra-loose monetary policy.
Growth momentum weakened in all countries. The IMF, in its WEO, published in April, reduced global output growth to 3.6% each in 2022 and 2023, from 6.1% in 2021. While growth faces multiple headwinds such that high and high commodity prices, especially crude oil, a protracted conflict between Russia and Ukraine and a possible sovereign debt crisis to come, a further deceleration in growth seems imminent due to increases in aggressive rates from systemically important central banks.
Why are central banks so aggressive in a situation where growth is slowing down? Have they been behind the curve for a while and therefore aggressive in raising policy rates now?
There has been a legacy problem of excess liquidity for quite a long time following the global financial crisis (GFC). While monetary policy normalization was underway before the Covid pandemic, it was incomplete. The balance sheet size of major central banks was quite large.
The Fed Reserve balance sheet, which was below $1 trillion before the GFC, remained stubbornly above $4 trillion until December 2019 when the Covid crisis hit. To sustain growth, adequate policy space has not been created to deal with another crisis.
Central banks loosened their purse strings in the wake of the Covid pandemic as it was an unprecedented health catastrophe. The size of the Federal Reserve’s balance sheet alone has more than doubled to about $9 trillion in two years.
While central bank support was unavoidable during the Covid crisis, delays in political decision-making on monetary policy normalization led to inflationary pressures spiraling out of control almost everywhere. Central banks appear to have misjudged inflationary pressures as transitory, resulting from Covid-related supply shocks.
Looking back, it can be argued that central banks failed to create enough policy space long before the Covid crisis. The same mistake was also made again in the post-Covid period by tolerating/dismissing inflation as transitory. They were obviously behind the curve for a while. Therefore, aggressive rate hikes are needed now to contain inflationary pressures in most countries. The most likely outcome would be stagflation all the way. Moreover, an increase in sovereign yield would pose a serious debt servicing problem globally.
While India’s growth slowdown was highly visible since 2017-18, long before the Covid crisis hit, the RBI has pursued an accommodative monetary policy since February 2019. In the wake of the Covid crisis, the RBI has started firing on all cylinders to support growth. Monetary policy has become ultra-accommodative, while regulatory and liquidity management policy has taken a head start to complement monetary policy initiatives.
For quite a long time, short-term rates have been well below the repo rate. Conventional monetary policy was coupled with unconventional measures, which flooded the financial market with unprecedented excess liquidity, at times exceeding ₹9 trillion.
Like many systemically important central banks, the RBI interpreted CPI inflation as temporary due to supply shocks, even though it was above the tolerable limit of 6% in 2020-21 .
In 2021-22, India’s average CPI inflation was slightly below the upper tolerable limit. The Russo-Ukrainian war and the concomitant rise in world crude oil prices radically changed the situation, complemented by the rise in pent-up demand, both domestically and globally.
Currently, India is facing widespread inflation due to external and internal factors. CPI inflation of 7.8% in April was a wake-up call for the Monetary Policy Committee to raise the off-cycle repo rate by 40 basis points in May, an increase of 50 basis points of the CRR, followed by another repo rate of 50 basis points. hike in June.
It will take some time for the real policy rate to be positive unless the RBI raises the policy rate aggressively. To curb inflation expectations, can the RBI wait for the real policy rate to turn positive before announcing the change in monetary policy stance to neutral or tight?
The current monetary policy stance is ambivalent – neither accommodative nor neutral – as it focuses on a calibrated withdrawal of accommodation. Given that the daily excess liquidity is currently over ₹7 trillion, it is unlikely to quickly reach a net liquidity shortfall, which is a desirable condition of liquidity management, at least in a phase of monetary policy tightening.
The draining of excess liquidities, advocated previously, could not then be continued because of its likely impact on the sovereign yield. The time is up for the RBI to show agility in controlling inflation.
The author is RBI Chair Professor, Utkal University, and former Senior Advisor and Head of Monetary Policy Department at RBI
June 12, 2022