The concern of inflation is spreading rapidly all over the world. Price pressures are not uniform across countries, despite the fact that they have all been affected by similar supply shocks over the past two years. What is different is the extent of demand stimulus that various governments have injected into their economies in response to the crisis. Thus it is quite likely that the extent of the stimulus explains the different colors on the global inflation heat map, although trade intensity will also play a role.
One way to assess risk in different countries is to examine how far inflation has departed from formal or informal inflation targets. There are three groups of countries. The first group includes countries such as the US, Brazil, Germany, Mexico and the UK, where the most recent inflation readings are well above targets. The second group includes countries such as France, South Korea, Taiwan and South Africa, where inflation is slightly above comfort levels. And then there are countries where inflation is still below target. These countries include Japan, China, Indonesia and the Philippines.
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What about India? Much depends on how the inflation target is interpreted. Inflation in February was slightly higher than the upper end of the 2-6% range that the Reserve Bank of India (RBI) has given to the government as its formal target. However, it is 2.1 percentage points above the midpoint of the inflation target band. The whole idea of giving the Indian central bank a range rather than a point target is to ensure that it does not react too hasty to temporary supply shocks. However, both inflation and core inflation have remained high over the past 30 months. There is also the risk that inflation expectations will lose ground if these price pressures persist for too long.
The economy is yet to see any generalized wage pressure, but several Indian companies have signaled to their shareholders that they will pass on higher input costs to their consumers. The RBI is expected to raise its inflation forecast later this week, which is significant as the inflation-targeted central bank uses its inflation forecast as an intermediate target for monetary policy. It will be an interesting high-wire act to see how the six members of the Monetary Policy Committee (MPC) respond to the forecast for high inflation when they meet this week.
There is a weak case for raising the repo rate right now, but the market interest rates have been rising for the past few weeks. So are bank deposit rates. However, there is a strong case for some combination of a higher reverse repo rate, with the change in policy stance for financial markets maintaining neutral and neutral guidance.
Most of the public discussion on Indian inflation has focused on the real side of the economy. The rest of this column looks at another set of issues that deserve some attention—on the monetary side.
Like its peers across the world, the RBI inflated the economy with liquidity to save the economy when the covid pandemic brought the world to a standstill. The four main fundamental drivers of liquidity in the economy are net purchases of foreign currency by the central bank, the government’s cash balances, excess commercial bank reserves with the central bank, and currency in circulation (which is cash kept in bank vaults. cash holdings of the firms).
Since the start of the pandemic, Indian households have been holding more cash for precautionary reasons, even as digital payments are increasingly being used for transactions. This excess cash holding—about 1.6 percentage points in terms of stock of broad money in India compared to pre-pandemic levels—has been a ‘leak’ from the liquidity generation process. A quick guess is that Indians now hold 3.12 trillion additional cash as compared to the financial year ended March 2019.
Decisions to hold more financial savings in the form of cash rather than bank deposits have reduced the pace of money earnings in India, or the proportion of our GDP as a nominal in stock of broad wealth (GDP/m3). reduced in. look at the chart. What does this mean in practical terms? The rate at which money flows through the economy has been reduced as a precaution because of cash kept in cupboards or under mattresses. The low income velocity of money essentially means that the inflationary consequences of monetary expansion will be less than anticipated.
Today some would argue that inflation is determined only by monetary factors, but they matter. So the question is worth asking: will there be an additional monetary push to inflation once the velocity of money income returns to normal in India? This may seem like a trivial matter in a world where the real shocks are in the headlines, but it is still something that India’s central bank needs to pay attention to. To borrow from the title of a 1981 paper by Thomas Sargent and Neil Wallace, monetary arithmetic can sometimes be unpleasant.
Niranjan Rajadhyaksha is CEO and Senior Fellow at Earth India Research Advisors and a member of the Academic Advisory Board of the Meghnad Desai Academy of Economics.
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