Rising inflation, impending recession

Remember the lines from Samuel Taylor’s Coleridge’s, The Rime of the Ancient Mariner: “Water, water, everywhere/Nor any drop to drink!” The state of the world economy is similar to that of the legendary mariner, “alone, alone, all, all alone/alone in a wide, wide sea”.

Without the latest data on retail inflation and industrial output, which were yet to be released only the next day, Finance Minister Nirmala Sitharaman, facing reporters during her visit to Washington for the International Monetary Fund-World Bank Biennial Meeting, had to be circumspect. She told them, “the specifics of the next budget may be difficult at this stage but growth would receive top priority…Inflation concerns will have to be addressed”.

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The data released the next day revealed that retail inflation in September was at a five-month high at 7.4 per cent, up from August’s 7 per cent, and exceeding the permitted tolerance level of 6 per cent for the ninth month in a row. Further, industrial output growth contracted to 0.8 per cent in August, with decline in mining and manufacturing of consumer goods resulting from supply-chain disruptions of inputs from overseas and the global slowdown due to the Russia-Ukraine war adversely impacting trade and India’s export earnings.

In August, after raising the policy interest rate by 50 bps to 5.40 per cent (the current rate effective from September 30 is 5.90 per cent), RBI Governor Shaktikanta Das had, in his press conference, observed that the Indian economy was an island of “macroeconomic and financial stability in the ocean of economic turmoil”. The IMF’s latest World Economic Outlook, October 2022, released before the biennial meeting, confirmed RBI’s assessment, although with a downward revision of world growth forecasts, putting India ahead with 6.8 per cent for 2022 and 6.1 per cent for 2023, followed by China, with corresponding rates of 3.2 per cent and 4.4 per cent.

Global economy

Global growth is expected to slow down to 3.2 per cent in 2022 from 6 per cent in 2021 and to decrease further to 2.7 per cent in 2023. This is the “weakest growth profile since 2001, except for the global financial crisis (2007-8) and the acute phase of the Covid-19 pandemic (2019-21)”. Global inflation is forecast to rise from 4.7 per cent in 2021 to 8.8 per cent in 2022 but decline to 6.5 per cent in 2023 and to 4.1 per cent by 2024. The inflation forecasts for the advanced economies for 2022 and 2023 are US: 8.1 per cent, and 3.5 per cent, Eurozone: 8.3 per cent, 5.7 per cent; and emerging market economies are India: 6.9 per cent and 5.1; and China: 2.2 per cent and 2.2 per cent.

The US Federal Reserve delayed its response to rising inflation ever since March 2021, when the targeted rate of inflation of 2 per cent was breached. The Fed kept the policy rate low, close to 0 per cent, in the belief that the signs of rising domestic prices were transient and due to transitory factors. But when inflation signs became “real”, it woke up and raised the rate in March this year to 0.25 per cent, and in May to 0.75 per cent and steadily thereafter month by month from June to September to 3 per cent.

That has created another “taper tantrum”, similar to that of 2013-14 when the former Fed Chairman Ben Bernanke told the US Congressional Committee in May 2013 that the Fed would soon end the quantitative easing that began in 2008 to fight the global financial crisis. The decision was, however, not implemented until late December 2013. The mere announcement was sufficient to trigger the reversal of capital flows to the US, the world’s safe haven, from emerging market economies (EMEs), including India. Stock markets in EMEs crashed, with their currencies plunging against the US dollar.

In the open economy of the 21st century, the transmission of global market sentiments seeps through the “porous sands of geographical borders” at the “click of a mouse” at light speed. Although US share in world merchandise exports is just 8 per cent, the dollar’s share in world exports is 40 per cent as the prices of most of the traded commodities is denominated in USD. For many low-income countries struggling to reduce inflation, the weakening of their currencies has made the fight harder. The IMF has estimated pass-through of a 10 per cent dollar appreciation into domestic inflation at 1 per cent.

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Two options

Will central bank intervention in the market to prop up the currency help? Or will the depreciation or free fall be allowed?

As for the first, market intervention would be justified only for reducing high volatility and violent movements in exchange rate fluctuations. The limits to intervention are determined by the level of foreign exchange reserves. As regards allowing a free-fall in currency value, experience indicates that such a step has been found ineffective, and market players would only continue waiting for a further fall. This is known as the presence of information asymmetry. The 2013-14 taper tantrum experience of five EMEs (Brazil, India, Indonesia, South Africa, and Turkey), then referred to as the ‘fragile five’ is relevant here.

A former Indonesian Finance Minister, Muhamad Chatib Basri, who was handling the crisis in his own country, who is now a professor, told a Monash University seminar audience recently that expenditure cuts and other fiscal policy measures were more appropriate. He singled out India’s success in reining in government spending by trimming routine expenditure by 10 per cent. With the trade deficit contained and current account deficit improved, the Indian economy was able to rebound. The lessons are clear: High current account deficit can make an economy vulnerable, particularly if financed through portfolio investments. Policy measures to ensure investor confidence is essential to maintain stability. Exchange rate policy (allowing the exchange rate to depreciate) suffers from the presence of information asymmetry with higher risk in EMEs.

The alternatives are clear. IMF advises that in the short run, monetary policy should aim at restoration of price stability, and fiscal policy at alleviating the cost-of-living pressures with direct cash transfers to the poor, while at the same time adopting a tight fiscal stance aligned with monetary policy. Structural reforms are purely national in character. They should support the fight against inflation by improving productivity and easing domestic supply constraints.

(The writer is a former Senior Economist, Asian Development Bank, Manila. Currently, he is Honorary Adjunct Professor, Amrita School of Business, Bengaluru Campus)