Recently, I have been reading a lot of op-eds on how central banks, and especially RBI, should slow the pace of monetary tightening. Links to the best articles are mentioned at the end of this post. This post includes summaries of these articles and some direct quotes.

I was convinced by the arguments made in these articles.

Some studies and past wisdom tell us that –

1. Inflation moves up quickly but takes more time to cool down.
2. An increase in inflation in one country from 2% to 4% is quite different from a similar increase in another country from 8% to 10%.
3. Initially, when inflation is increasing, it also pushes inflation expectations upwards, at least in the short term. Later, even though inflation reduces, expectations stay high for some more time.
4. Inflation in India is very different from that of US. If we use the threshold of 1.65 standard deviations to examine the record in these two countries, then the current rise in Indian inflation does not qualify as an inflation surge, while the price situation in the US most certainly does. This does not mean that we should be sanguine about the situation in India.
5. Monetary policies of advanced economies have negative consequences on emerging markets.
6. Monetary policy affects real economic activity with a lag of three or four quarters.

Is global monetary policy in the right direction?

1. Chile has raised the policy rate by 10.75 ppt since July 2021. Despite this, inflation continues to be four times the country’s target due to a rise in energy costs and wages.
2. Brazil has hiked the interest rate by 11.75 bps but inflation is still expected to be above target in 2024.
3. Many people refer to Volcker’s rate hike policy of the late 70s. But they do not realise the context.
4. Volcker’s rate hikes were intended to combat a wage-price spiral by increasing unemployment, thereby reducing workers’ bargaining power and depressing inflationary expectations. But the high-interest rates triggered the largest decline in US economic activity since the Great Depression, and recovery took half a decade. Volcker’s policy also reverberated worldwide, as capital flowed into the United States, resulting in external debt crises and major economic downturns that led to a “lost decade” in Latin America and other developing countries.
5. But the context for this heavy-handed approach was very different from current conditions because wage increases are not the main driver of inflationary pressures. In fact, even in the US, real wages have been falling over the past year.
6. Research has increasingly shown that the current inflationary surge is driven by supply constraints, profiteering by large companies in critical sectors like energy and food, rising profit margins in other sectors, and commodity prices. Addressing these factors would require sensible policies such as mending broken supply chains, capping prices and profits in important sectors like food and fuel, and reining in commodity-market speculation.
7. Central banks are ineffective in handling supply-led inflationary pressures. Rather than taking measures to ease this pressure, elected leaders have shoved this responsibility on the central bankers. And central banks are relying on the blunt tools of interest rates.

India’s experience –

1. There is not enough evidence as yet that the spike in inflation has had significant second-round effects, unlike in many rich economies. These second-round effects of inflation—or the amplification of price shocks—usually happen through either the labour market or corporate pricing power.
   1. Indian labour market still has slack – refer labour force participation rate.
   2. Companies have a greater pricing power now.
2. Whether RBI should change interest rates to manage inflation or exchange rates?
   1. Economic theory tells us that each policy instrument should ideally be matched with one policy target.
   2. Ideally, RBI should manage the exchange rate by using its foreign exchange reserves, but the sharp fall in its war chest during the recent defence of the rupee means that the interest rate tool will have to be used for inflation control as well as curbing volatility of the exchange rate.

Therefore, a more wait-and-watch mode is preferred in the case of India. This does not mean a rate hike pause. But a smaller hike for once may be (for now). What’s your opinion?

Read these articles for more precise information. Also, use the comments section to add more article links to refine our understanding.

– Swapnil Karkare (summarised)

Sources and Further References:

Money Control –

https://www.moneycontrol.com/news/business/economy/why-india-slowing-monetary-tightening-will-be-the-right-call-9387521.html

Prof. Jayati Ghosh (Project Syndicate) –

https://www.project-syndicate.org/commentary/monetary-tightening-wrong-solution-for-current-inflation-by-jayati-ghosh-2022-11

Niranjan Rajadhyaksha -1 (The Mint)

https://www.livemint.com/opinion/columns/the-monetary-policy-committee-should-slow-its-pace-of-tightening-11668530335231.html

Niranjan Rajadhyaksha -2 (The Mint)

https://www.livemint.com/opinion/columns/why-inflation-usually-retreats-at-a-far-slower-pace-than-it-goes-up-11667320836529.html