The coronavirus outbreak left many economies in severe stress that led to a significant dose of policy push, from both the monetary and the fiscal side. Globally, central banks cut interest rates and also opened up their balance sheets to push adequate liquidity to prevent their economies from stalling.
Fiscal policies also did their bit. The fiscal monitor report from the International Monetary Fund (IMF) of April 2021 indicated that in 2020 for the world as a whole, the average government balances as a proportion of GDP was at a deficit of 11.7 percent compared to a deficit of 2.9 percent just a year back. For the G20 economies, the deficit was at 12.7 percent compared to 3.6 percent a year back.
Even six months ago, the talk was on the bleaker side—slow growth, unemployment and deflationary pressures were touted as the predominant risks to the globe.
Now, the focus has changed with inflation pressures mounting and the debate has been on whether the current inflationary trends are sustainable and if policies should be tightened.
The US Fed, in its recent monetary policy meeting, sounded hawkish as it upped inflation forecasts. Dot plots that show members’ expectations of the timing of the tightening indicate that two more members would go in for rate hikes by the end of 2023. However, in the press conference on June 16, Chairman Jerome Powell tried to cool nerves by saying Fed’s assessment for inflation pressures was transitory and that dot plots represent personal expectations and not a reflection of official thinking on policy.
Monetary policy going forward is thus likely to be a very delicate game. Any tightening ahead of schedule could lead to another round of slowdown. On the other end of the spectrum, any delay in tightening might mean inflationary expectations getting unhinged, leading to volatility in the financial markets and finally to an eventual dip in growth.
The tightening of monetary policy by the US Fed is also expected to have sizeable consequences for global financial markets, especially for the Emerging Market Economies. No doubt, the Indian rupee has depreciated following the monetary policy pronouncement by the US Fed.
A somewhat paradoxical situation has also emerged in India. While economists have all been reducing their expectations on growth recently after the second COVID wave hit India, they have, on the other hand, been upping their expectations on inflation.
After a reading of 4.23 percent for April 2021, headline CPI shot up to 6.3 percent in May 2021. The RBI has repeatedly stressed that the current high inflation trends have been due to supply-side disruptions and global commodity price upswing. But the moot point is how long will the RBI be able to tolerate such high inflation levels, especially in a scenario where it is above the upper threshold level of 6 percent of the targeting zone.
Further, if the supply-side shocks don't die out quickly but demand ramps up on the back of a better vaccination reach or if fears of further disruptions via a third wave recede, inflation can then become sticky and a problem for the RBI.
I am not suggesting that the RBI tighten interest rates and raise repo rates immediately. It has to be patient yet watchful with inflation or run the risk of pushing out a realistic chance of a bounce in the economy.
However, the RBI may be open to adjusting liquidity surfeit to a lower level and push up the short-term yields. On the other hand, it may also have to relax a bit of its hold on the government yield curve and allow for yields to rise to an extent, especially to protect flows in an atmosphere of a tightening signal from the US Fed.Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.