Inflation pipelines swelling as a long period of global macro instability begins

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As CPI inflation fell to 7 percent in May, some views have emerged it may have peaked in April at 7.8 percent. This is consistent with the Reserve Bank of India (RBI)’s quarterly inflation projection of June 8.

One needs to be careful these days though. The credibility of central banks the world over is under scrutiny.

One needs to look no further than the United States, where a large number of analysts had converged to the opinion that US inflation had peaked after it eased in April. Instead, the US’ annual inflation rate reversed in May, jolting expectations as had happened last October. It was really brave for the RBI to have ignored the significant amount of inflation stuffed inside the wholesale prices, which have been accelerating over a much stronger base. Only time will tell how much of that will be passed on to the retail buyers.

Consider the swelling pipelines of inflation. The first is wholesale price increases — those in the past that are yet to be passed on, and fresher additions each month. Strong corporate profits do not escape notice; neither does the regular revision of selling prices to consumers. Apart from the manufacturing goods’ burden, there’s the waiting passthrough of higher energy and electricity costs that many analysts have flagged; this includes a widening gap in retail and crude oil import prices, costlier coal imports, and electricity. Services’ inflation is waiting to catch-up more than it has. Food inflation isn’t entirely dependent upon monsoons either; wholesale prices grew into double-digits, 10.9 percent, last month, jumping two points over April.

The other pipeline to domestic inflation that is not imminently apparent is the exchange rate channel. The rupee will increasingly bear the fallout of expected as well as unforeseen changes in overseas monetary and financial conditions. The most obvious is US monetary tightening, where the main reference rate was hiked by 75-bps this week with strong indications of another 50-points next month and the sureness of a recession.

Additional tightening source is the US Fed’s balance sheet reduction or quantitative tightening (QT) that is estimated to remove approximately $95 billion per month according to a Financial Times report. Historically, the re-pricing of rates has been volatile, with currencies bearing the brunt of adjustment. This time, the new and unknown feature in a potent cocktail of high inflation and interest rates with slowing growth is the unprecedented level of debt stock in developed and emerging economies, bigger in the last. Another steady build-up of rupee pressure is the widening trade deficit, a growing risk.

We must note that this is only the beginning of a long period of macroeconomic instability. The US tightening cycle has just commenced. It has a long way to go. The RBI is no doubt mindful of all this. But it may be overoptimistic in keeping real rates negative. Inflation is entrenching globally. This is because of non-action and delay by central banks who allowed it to persist, embed into expectations and into their economies. In this context, the RBI’s sanguineness on inflation suggests that it considers India is an exception to this trend. This is simply unlikely.

Globally, central banks, particularly the US Fed, are being accused of negligence and poor judgement, leading to policy error that is now galvanising them into faster, steeper rate hikes to ‘catch-up’, and regain credibility. They are doubly charged with causing economic harm of severe proportions, which could range from losses and balance sheet damages to households, firms, and investors to straining debt-laden governments, and possible debt defaults. Of course, sending the world economy into a recession.

India cannot be insulated from these forceful readjustments. The notion that inflation is supply-driven needs re-examination. That demand factors have increasingly taken over requires consideration, e.g., the regular retail price revisions by profitable firms in the context of a K-shaped recovery creates grounds for rethinking, especially because of the inflationary squeeze to real disposable incomes of vulnerable low-income groups belonging to the lower stroke. Negative real rates need correction.

Renu Kohli is a New Delhi-based macroeconomist. Views are personal, and do not represent the stand of this publication.