Policy dilemma puts central banks in a tight spot

Inflation persistence poses a policy dilemma for central banks, forcing a delicate balance between growth and price stability.

Inflation persistence is one of the serious policy dilemmas faced by central banks. This will continue to pull policymakers in opposing directions for some more time to come. This is similar in the case of both the US and India. The rate hikes in the US have led to a disinflationary effect to set in, but inflation is yet to come down. In fact, the rate of inflation is far away from the long-term inflation target of the Federal Reserve.

What comes to play at this juncture is the inflation-growth trade-off. This is not an easy call. While the general public may be preoccupied with high consumer prices, markets are almost always hooked on to the obvious growth narrative. At the end of the day, growth will be sacrificed to a certain extent for the sake of price stability. This is because the central banks are not in a position to accurately estimate the policy dosage required to exactly stop where it starts hurting the real economy. The monetary system is not like a machine which stops when the brakes are applied. Therefore, the pain will gradually set in and stay around for some time.

Weaker Dollar

The dollar index has moved down all the way down from 114 to 101, though it has moved up a little bit from the lows, reflecting a waning of the dollar’s strength. The cheaper dollar again sows the seeds of price pressures. The dollar weakness almost always translates into higher prices for commodities including gold and oil. These commodity prices have a cascading impact, through the exchange rate on to the prices of fuel and freight charges and transportation costs, and finally, the prices of articles like fruits and vegetables.

Therefore, a downcycle on dollar fortunes, occasioned by stable or moderate monetary policy leads to a spiral of high prices. This is exactly the other side of what high fuel prices and inflation and the consequent rate hikes brought to our doorstep. It looks like inflation persistence needs to be fought through for an extended period of time.

Back home, the Union Budget had many sterling propositions such as the expansion of agri-credit to the extent of Rs 20 lakh crore and the attempts at crowding in private capex with public capex of Rs 10 lakh crore. These propositions are more consistent with, or rather more effective with, an expansionary policy rather than a restrictive one.

Inflationary pressures

The latest consumer price index (for January 2023) indicates a pick-up in inflation, which had been in a reversing trend in the last two months. The tone of the last the Reserve Bank of India (RBI) policy statement has done the right thing to sound more hawkish on the inflation containment objective. The RBI may be compelled to further hike rates due to the inflation level, which is still perched at higher levels, the widening current account deficit and the need to protect the currency from sharp depreciation.

At the same time, the government needs to mobilise resources through market borrowing, an amount that is almost as big a size as that of the current fiscal. The borrowing programme for the current year had sailed through smoothly due to favourable liquidity conditions. But since mid-year, the liquidity has been dwindling and it is near flat at present. Where does the fresh liquidity come from? The RBI will have to add liquidity to the system or may have to let devolvement happen on the primary dealers who could be financed by it. A source of liquidity, like the overseas money flowing in, has ceased, and it may be some time before it resumes.

Can the RBI add liquidity at a time when it is battling inflation? Or, do we look at much higher money market rates and borrowing costs? The persistence of inflation and the need to be expansionary to spur growth are trying to draw the cart in opposite directions. The dilemma persists. The ray of hope is that very few central banks are as equipped and as skilled as the RBI to manage such situations.

Written by Joseph Thomas. Mr. Thomas is Head of Research at Emkay Wealth Management. Views are personal and do not represent the stand of this publication.