CPI inflation may be at around 8% in India, but the WPI inflation is as high as 15% and has been in double digits for 14 months now, and the last time we saw this was from March-1994 to May-1995.
Till September 2021, the central banks were expecting the inflation to be transitory due to the opening up of the economies.
Later as the inflation became sticky, and the interest rates started increasing and remained consistent, central banks started changing their stance and started withdrawing liquidity that they had been passing on by buying bonds.
After the withdrawal of liquidity, they started hiking rates and now Fed will be starting to reduce its balance sheet size. Let’s analyze the genesis of inflation, the reasons for current inflation, and what the future prospects are.
The economic definition of inflation is a general increase in the prices of goods and services over a given period of time.
As the prices rise each unit of the currency buys fewer goods and services which indicates that inflation corresponds to a reduction in the buying power of the money.
A rapid, excessive, and out-of-control increase in prices of goods and services is called Hyper Inflation (where prices increase by more than 1,000% annually).
Hyperinflation is generally rarely seen in developed economies but we have seen bouts of such inflationary rise in Argentina, Venezuela, Russia, and more recently in Sri Lanka.
The Western economies generally find inflation of 2% most consistent for maximum employment and price stability. The current rate of inflation in most economies is around 8% and cannot be termed Hyperinflation.
REASONS FOR THE CURRENT INFLATION
The main reasons for the current inflation are:
Supply Chain issues: Increases in labour, energy and transport costs are contributing to rising in the current prices of goods and services. Still, the inflation-adjusted earnings are down by 2.5% as compared to last year. That means a worker has lower buying power than a year ago.
2. Demand for commodities as markets opened up after the lockdowns seen in 2020 and part of 2021.
3. The excessive liquidity parked by central banks and the spending done by various governments to curb the effects of the pandemic. This was about $9 trillion and slowly it was excessive money chasing too few goods thus stoking inflation. Probably the urge to recover from the lows of the pandemic impelled the global economies to go overboard on monetary and fiscal support. The result was runaway inflation in most global economies.
4. Increase in cost of logistics particularly shipping costs. Non-availability of containers pushed shipping costs manifold, thus increasing the cost of commodities and increasing inflation.
CENTRAL BANKS STRATEGIES IN MANAGING INFLATION
All major central banks in the world have been given inflation targeting to keep it in a particular band with the majority of them targeting it between 2-3% and some like RBI keeping it in a range of 4-6%.
As the lockdown was lifted the demand for most of the commodities rose and therefore the central banks showed an inclination towards marking the inflation as transitory and that the rapid pace of prices will moderate with time.
Immediately after the reopening, the suppliers could not match the sudden demand for goods, and prices started to rise at the start of 2021.
However, apart from the supply concerns, it was a large amount of money floating around the world that was causing inflation (too much money floating chasing too little goods).
It was as late as December 2021 that the central banks were able to identify that inflation was not transitory but sticky. The US Fed first began by reducing the amount of bond buying and later in March 2022 made a small rate hike of 0.25%.
Later they increased rates by 0.50% in May 2022 and also said that they will start a reduction in assets on their balance sheet as early as June 2022.
So, it looks like the central banks were unable to identify the root causes of the inflation and were considering it to be transitory for the most part of 2021.
As inflation due to goods rose it also caused an increase in wages to match the inflation. The supply disruption of most goods caused due to the war between Ukraine and Russia added fire to the heat thus increasing the rate of price increase since February 2022.
The Brent has risen to $123 per barrel and will be giving major headwinds to all economies in the world. Recently, the eurozone inflation rate hit 8.1% its highest since the creation of the euro in 2000.
In the US, consumer inflation is at a 42-year high of 8.3% forcing a prolonged spell of hawkishness from the Fed at the cost of GDP growth which has fallen to -1.5% in the first quarter.
Excessive liquidity has callused runaway inflation in India as the rate is above 4% for over 35 months and above the tolerance limit of 6% for 6 out of the last 12 months.
RBI has been busy draining liquidity. It raised CRR by 50 bps in the last unscheduled meeting while it also increased the repo rates by 40 bps. It further raise rates by 50 bps in its policy meeting on 8th June.
FED is expected to raise rates on 15th June by 50 bps and again by the same quantum in July Meeting.
ECB is also expected to come out of negative rates in its July meeting. Most central banks in the world have been raising rates some being very hawkish to tame the inflation.
Inflation could get tamed in the next six months due to the aggressive tightening policies of most of the central banks and rate hikes thus reducing the demand for the goods and services but could result in growth being tapered down.
In fact, a number of analysts are expecting a recession in the US and a slowdown in growth in most major economies. RBI is confident that it will weather this macro crisis in FY23.
As the RBI tightens, the policies of the government will also help.
All these measures are aimed at taming inflation. The GDP and inflation could get worse in the coming months due to the measures but a good monsoon and a better agricultural output could put the economy back on track towards the end of the financial year.
(The author is Head of Treasury, Finrex Treasury Advisors)