Indranil Pan, Chief Economist at YES Bank
Inflation has been running red hot in many economies of the world. However, Covid-19 was expected to have slowed consumption and built up precautionary savings. The messaging from the central bankers around the world has been that the supply chain disruptions lie at the root of high inflation and are likely to be ‘transitory’. What is confusing for the central bankers is probably the fact that the transitory phase has been running much longer than was earlier expected.
Surely a pressure is building up on the central banks around the world to dial back the easy monetary policy. But, on the flip side, the apex bankers are still not sure if the recovery process has been strongly entrenched in the respective countries. There are evidences of stagflation also building up – where inflation is higher, but the expansion slows. Unlike in the financial market crash of 2008, this time the picture is getting complicated by the virus spread, emergence of delta variants, many across the world are still not vaccinated and vaccination hesitancy continuing.
The problem with supply chain is not new and will also probably persist. Prior to the outbreak of the virus, we had the US-China trade spat that had probably altered the way businesses looked at investing in supply chains and had pulled back capital spending. This was further impacted by Covid-19 and could lag in its recovery given the uncertainties of the virus and the unclear nature of consumer behaviour in the current atmosphere.
It is apparent that the supply-led inflation problems will sustain while the central bank continues to look for signs of demand-led inflation. Fed Chair Jerome Powell has alluded to this repeatedly as he acknowledged that more enduring bottlenecks could hold inflation at higher levels for much longer than expected. To a large extent, the job of the central banker now is to manage expectations on inflation. Indeed, the chairman pointed out that the Fed would raise rates if they saw evidence that the higher prices were pushing up inflation expectations – right now there is no evidence of that. Having said that, the central bankers would also not want to be late in lifting off as then the brakes will have to be slammed hard.
The core view in the market is that the US Fed will start reducing its massive bond-buying programme in November. But the Fed chair has also hedged his position by indicating that there could be course corrections on the way if somehow the recovery stumbles. Remember that the US is all ready to withdraw the unemployment benefits – something that had skyrocketed the savings of households and was used to support consumption. Overall, it may be the case that contrary to market expectations, the withdrawal programme will not be put on auto-pilot mode.
Various central banks are at various phases of withdrawing from their easy monetary policy. While the US has signalled that tapering could come soon, the Bank of England hinted that it might raise interest rates this year. The Bank of Japan shows no signs of dialing back the stimulus, while on the other hand, Norway was the first developed economy to hike rates while increases have happened in Brazil, Paraguay and Hungary. However, for the G-4 economies, the test for tapering will be less stringent but the bar for hiking will be quite high. Effectively, I would expect global monetary policy to continue to look relatively easy into 2022 – the pace of bond purchases could come down but the balance sheet size of the central banks would not be reduced from current levels.
In India too, the RBI is fighting a battle – a battle to convince all that inflation could be running close to the upper threshold levels and yet the RBI would be willing to look away as inflation is explained to be supply-driven and transitory. In one of the recent studies, the RBI also had highlighted Covid-19 followed by Changed Data Collection Methodology had boosted the mark-up of some food items, thereby leading to a higher food inflation.
Markets are looking up to the RBI to guide them on how much liquidity surfeit the central bank would be comfortable with. However, it is extremely unlikely that the RBI will take any sudden measures before preparing the market for it. The question thus remains – is the RBI trying to signal something through the higher cut-off rates at the recent VRR (Voluntary Retention Route) auctions and at the OMO (open market operations) auctions? Bond players and the OIS (overnight index swap) market are pricing in a reverse repo rate increase at the RBI’s October policy. Just a day from now we will know if the RBI would spring a surprise on the markets.