CPI inflation may be around 8% in India, but WPI inflation is at 15% and has been in double digits for 14 months now, and the last time we saw it was from March 1994 to May 1995.
Until September 2021, central banks expected inflation to be transitory due to the opening of economies.
Later, when inflation got sticky and interest rates started to rise and remained constant, central banks began to change stance and withdraw the cash they had passed on by buying bonds.
After the cash was withdrawn, they started raising rates and now the Fed is going to start shrinking the size of its balance sheet. Let’s analyze the genesis of inflation, the reasons for the current inflation and what are the prospects for the future.
The economic definition of inflation is a general increase in the prices of goods and services over a period of time.
When prices rise, each unit of currency buys fewer goods and services, indicating that inflation is a reduction in the purchasing power of money.
A rapid, excessive and uncontrollable increase in the prices of goods and services is called Hyper Inflation (where prices increase by more than 1000% per year).
Hyperinflation is generally rarely seen in developed economies, but we have seen episodes of such inflationary spikes in Argentina, Venezuela, Russia and, more recently, Sri Lanka.
Western economies generally find the most consistent 2% inflation for maximum employment and price stability. The current inflation rate in most economies is around 8% and cannot be called hyperinflation.
THE REASONS FOR THE CURRENT INFLATION
The main reasons for the current inflation are:
Supply chain issues: Rising labor, energy and transportation costs are contributing to higher current prices for goods and services. Still, inflation-adjusted earnings are down 2.5% from a year ago. This means that a worker has less purchasing power than a year ago.
2. Commodity demand as markets opened after the shutdowns seen in 2020 and part of 2021.
3. Excessive cash parked by central banks and spending by various governments to curb the effects of the pandemic. It was about $9 trillion and slowly it was too much money chasing too few goods thus fueling inflation. The urge to recover from pandemic lows has likely pushed global economies to overdo monetary and fiscal support. The result has been runaway inflation in most world economies.
4. Increased cost of logistics, especially shipping cost. The non-availability of containers has pushed shipping costs to a slew, thus increasing the cost of raw materials and increasing inflation.
CENTRAL BANKS’ STRATEGIES IN INFLATION MANAGEMENT
All major central banks in the world have been given inflation targeting to keep it within a particular range, with the majority of them targeting it between 2-3% and some like RBI keeping it within a range of 4-6%.
When the lockdown was lifted, demand for most commodities increased and so central banks showed a tendency to mark inflation as transitory and that the rapid pace of prices will moderate over time.
Immediately after the reopening, suppliers could not meet the sudden demand for goods and prices began to rise in early 2021.
However, supply issues aside, it was a large amount of silver floating around the world that caused inflation (too much floating silver chasing too few goods).
It was not until December 2021 that central banks were able to identify that inflation was not transitory but persistent. The US Fed first started by reducing the amount of bond purchases, then in March 2022, it proceeded with a slight rate hike of 0.25%.
Later, they raised rates by 0.50% in May 2022 and also said they would start reducing assets on their balance sheet as early as June 2022.
It therefore appears that central banks were unable to identify the root causes of inflation and viewed it as transitory for most of 2021.
As inflation due to goods increased, it also caused wages to rise to match inflation. The disruption of supply of most goods caused by the war between Ukraine and Russia has added fire to the heat, increasing the rate of price increases since February 2022.
Brent has reached $123 a barrel and will create major headwinds for all economies around the world. Recently, the inflation rate in the euro zone reached 8.1%, its highest level 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 period of Fed hawkishness at the cost of GDP growth that has fallen to -1 .5% in the first quarter.
Excess liquidity has neutralized runaway inflation in India as the rate has been above 4% for more than 35 months and above the 6% tolerance limit for 6 of the past 12 months.
RBI has been busy draining cash. It raised CRR by 50bps in the latest unscheduled meeting while raising repo rates by 40bps. It raised rates another 50 basis points at its June 8 policy meeting.
The Fed is expected to raise rates on June 15 by 50 basis points and again by the same amount at the July meeting.
The ECB is also expected to exit negative rates at its July meeting. Most of the world’s central banks raised rates, with some being very hawkish to control inflation.
Inflation may be brought under control over the next six months due to aggressive tightening policies by most central banks and rate hikes, reducing demand for goods and services, but could lead to reduced growth.
In fact, a number of analysts are expecting a recession in the United States and slower growth in most major economies. RBI is confident that it will overcome this macroeconomic crisis in FY23.
As the RBI tightens, government policies will also help.
All of these measures are aimed at controlling inflation. GDP and inflation could worsen in the coming months due to the measures but a good monsoon and better agricultural production could put the economy back on track towards the end of the financial year.
(The author is Head of Treasury, Finrex Treasury Advisors)