Geopolitical factors have led to inflation, but the headache is ours

As the pace of globalisation has slowed down, the consequences on the economy is serious and the solutions are difficult and unpopular. (Illustration by Suneesh K.)

Since quantitative easing (QE) has become part of the conventional monetary policy tool for most of the advanced economies, the spillover effect of these policies has gained prominence. Almost all central bank policies are expected to impact the real economy, given their effect on financial markets. While the pace of globalisation in the current account (i.e. goods and services) has slowed during the past decade or so, the inter-linkages among financial markets (i.e. capital or financial account) are only getting stronger. These facts have serious consequences on the real economy, and the solutions are definitely difficult, and unpopular.

There are three types of central banks in the world:

One, those that don’t intervene in the forex market at all (like the US Federal Reserve, the European Central Bank, and the Bank of England).

Two, those that maintain a fixed or pegged currency against the USD (like the People’s Bank of China, the Swiss National Bank, the Monetary Authority of Singapore, and the Central Bank of Republic of China (Taiwan)).

Three, those that are somewhere in the middle of these two extremes (like the Reserve Bank of India, the Bangko Sentral ng Pilipinas, and the Bank of Thailand).

It is important to note that some advanced economies fall into type two, while some emerging markets fall in the first category. Inflation-targeting central banks may also be tempted to intervene in the forex market as sudden and excessive movements in domestic currency can affect inflation as well.

The spillover effect of QE by major central banks (falling in type one) makes the life of central banks in type two and type three very difficult. Like all other interventions, the intervention in the forex market by a central bank comes at a cost. For any central bank, there are only two asset markets: government securities and foreign exchange. Since central banks in the first category do not intervene in the currency market, they are absolutely free to support or tighten the domestic bond market, and thus practice an independent monetary policy.

In order to support currency levels, an independent monetary policy is not possible for central banks falling in the second category. The more the central banks (falling in type three) try to influence the currency, the lesser is their scope to follow an independent monetary policy. If a central bank has an eye on its currency against the USD, which is directly linked with foreign capital flows, it tends to import the US monetary policy. The trade-off between the currency and the domestic bond market is real for currency-intervening central bank economies.

While the US Fed is drafting its policies based on its national objective, the other central banks are left with two options. First, if it doesn’t intervene in the forex market (and behaves like the type one category), its currency will either strengthen or weaken based on foreign capital inflows or outflows. Based on domestic fundamentals, the bank can pursue an independent monetary policy by practicing more influence on the domestic bond market. As the currency adjusts, it is likely to overshoot on either side, as is the case with most financial markets. When that happens, market analysts will start worrying about overshooting of the currency, likely leading to its reversal, initiated by the self-fulfilling fears of foreign investors. Therefore, the free market ensures that the currency falls back towards its equilibrium eventually, while the central bank maintains full autonomy over its monetary policy.

Alternatively, if the other central banks decide to intervene in the forex market, it will either cut or raise domestic interest rates to discourage foreign capital inflows or outflows. Historical experiences suggest that the forex market is truly global, and tends to follow global sentiments and USD movements. In other words, foreign capital flows are driven more by global policies and sentiments, rather than domestic policies. The inability to control foreign capital flows, and either the depreciation or appreciation in the domestic currency, will lead to an over-reaction from the respective central bank in the form of an excess interest rate action. This will, however, have an impact on domestic economic growth.

In case, the other central banks choose to sterilise their forex interventions by either selling or buying G-Secs during the period of high foreign capital inflows or outflows, domestic interest rates will move accordingly. It is, thus, equivalent to the case where foreign capital flows, led by global policies and the US Fed, influence the monetary policy of other currency-intervening central bank economies.

Although it is widely believed that higher interest rates are required to mitigate depreciation in the USD:INR, there is not enough evidence to prove this hypothesis. It is unarguably true that the movements in the rupee are more linked with other important factors. What otherwise explains the 6.5 percent depreciation in the USD:INR in 2022 (as of August 17) after a cumulative hike of 140 bps in the repo rate, as compared to 6-7 percent depreciation in the Malaysian Ringgit and the Thai Baht, which have hiked rates by only 50 bps and 25 bps, respectively, and the 3 percent weakness in the Indonesian Rupiah, which is yet to begin its rate hike cycle?

The RBI has hiked the repo rate by 140 bps since May (and the Standing Deposit facility, which is the operational rate, by 180 bps since April), and it is generally expected to raise rates by another 50-100 bps over the next six-to-nine months. There is no doubt that inflation is high in India. However, a large portion of the excess inflation (i.e. more than the 6 percent target ceiling) is on account of geopolitical factors. At the same time, unlike the western world, the economic growth is also weak in India, demanding more cautious monetary tightening. Therefore, the current rate hike episode seems aggressive, possibly driven by the US monetary policy, and the fears of a large depreciation in the USD:INR, rather than domestic fundamentals.

At the same time, it is highly perplexing that RBI’s FY23 real GDP growth projection has been kept unchanged at 7.2 percent since April. How can the RBI or market participants expect higher interest rates to affect inflationary pressures, unless it is successful in hurting GDP growth? The US Fed has cut its growth projection for 2022 to 1.7 percent in June from 2.8 percent in March (when the first rate hike was announced. It will probably reduce it further when the new projections are presented in September. All this suggests that growth downgrades are imminent in India.