Globalisation of inflation and monetary policy making
The CPI in India in November 2021 was close to 5%, while the core inflation was above 6% and WPI above 14%. Not only in India, but globally inflation is high. In the US, it is above 6%, well above their target of 2%. So, inflation is back globally for the first time in decades, but this time it could be different. What should central banks, particularly those in emerging market economies, do?
The MPC in India, in the last meeting, decided to keep status quo both in terms of repo rate and accommodative stance. In a statement released, the MPC lists factors that might impact inflation in India – most of them, except edible and crude oil prices and a mention of global logistics bottlenecks, are domestic. There is no indication that MPC is taking into consideration the global inflationary surge and the resultant dynamics of monetary policy in other countries. This raises the question that whether an outdated lens is being used.
Much of the theory and understanding of inflation comes from studying the high inflation periods of the past, particularly in advanced economies (AE), in a closed economy setting. The last major episode being the Great Inflation period in the USA between 1965 and 1982. The world was very different then. The only global factor monetary authorities worried about was crude oil prices. Now it will be a grave mistake to not acknowledge the globalization of inflation and spillover of monetary policy across borders, especially in emerging market economies (EME).
Over the last three decades inflation has become much more synchronised, not only in advanced economies, but also in emerging economies. As the graphs show, the spread of inflation across countries has decreased significantly in both groups of countries.
What are the possible reasons for this increased co-movement of inflation? One reason could be that it is driven by common shocks, like the fluctuations in crude oil. However, this cannot explain why inflation has become more synchronized over time. More likely, it can be attributed to two other reasons – structural change in the world economy, and evolution of monetary policy.
Over the last few decades, the world has become increasingly globalised. Trade intensity has increased in both AEs and EMEs. The nature of production has also changed significantly. Value chains have become fragmented and distributed across multiple nations. Global value chain related trade, defined as the value added that has crossed at least two national borders, has risen rapidly. To an extent, the genesis of the current surge in inflation lies in this. Disruptions in the global supply chain has led to a shortage in supply in certain sectors because of this deep cross-border linkages. However, even without disruptions, it is clear that price rise in any country is now bound to have repercussions in other countries. Thus, focussing entirely on domestic factors in determining monetary policy response may not be enough.
Convergence in monetary policy is another reason why inflation is much more in sync across countries. Since the last sustained high inflation period in the 70s, there has been a sea-change in monetary policy making, and quite importantly it has become, broadly speaking, similar across countries. Since early 1990s, starting from New Zealand, more and more countries have adopted inflation targeting. India is a latecomer to this group, and adopted inflation targeting in 2015. For AEs this goes a step further –target inflation rate has also converged to 2%. This convergence of monetary policy is not limited to conventional monetary policy of setting interest rates, often asset purchase programs have also happened in tandem. The latest demonstration of that has been in March 2020 when, following the onset of the Covid pandemic, an outflow started from the EMEs and the Cboe volatility index (VIX) shot up. A concerted effort in announcing asset purchase programs, in both AEs as well as EMEs, stemmed the outflow from EMEs and VIX came down to a lower level.
However it is not guaranteed that this kind of cohesion in monetary policy seen during the low inflation era will continue and, going forward, a big risk is that monetary policy may not be that well-coordinated across countries. The economic recovery might be asynchronous across countries. Central banks may have different inflation appetite depending on domestic factors including election cycles. This will take the world to an unfamiliar territory. In particular, the impact on emerging economies can be severe because of the externalities from the monetary policy decisions of other nations. Any sudden move by them can lead to a situation far worse than the taper tantrum of 2013. Now that inflation in the US has persisted above 6%, it is imminent that Fed will swing into action. Is MPC prepared for that?
The MPC in India has been rather dovish so far and focussed more on supporting economic recovery than tackling inflation. There is a fine line – beyond a threshold, increase in inflation can be highly non-linear and it can spiral up very quickly. The safest way is to tackle inflation early on. The MPC keeping repo rates unchanged was probably expected, but continuing with the accommodative stance is questionable. Moreover, while MPC rightly identifies financial tightening globally as a risk factor to the recovery of the economy, it does not seem to acknowledge the globalization of inflation, nor any indication that it is prepared for an era of asynchronous monetary policy making across the globe and dealing with the spillover of monetary policy actions in the advanced economies. This is the time when the MPC has to establish its reputation in fighting inflation. It needs to acknowledge and identify the global risks and act accordingly.
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