Economic Indicators and Various Reports On It- GDP, FD, EODB, WIR etc

Monetary tightening and its impact on growth

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Core inflation

Mains level : Paper 3- Inflation challenge

Context

A rate hike in the monetary policy committee’s June meeting was a foregone conclusion after the spike in inflation and an off-cycle surprise interest rate hike on May 4.

Reasons fast forwarding of interest rate hike

  • 1] Broad based inflation: A confluence of factors has pushed inflation higher and made it persistent and broad-based. 
  • 2] Policy rates are still negative: Even with this hike, the repo rate, the signalling tool for bank interest rates, is still below pre-pandemic levels.
  • The real policy rate (repo rate less expected inflation) remains negative and has some distance to cover before it reaches positive territory — where the RBI would like to see it.
  • 3] Lag in effect: Monetary policy impacts growth, and thereafter, inflation with a lag.
  • To control inflation, the RBI needed to act faster by front loading rate hikes.
  • 4] Elevated inflation expectations: The risk of inflation expectations getting unmoored had risen.
  • Household and business inflation expectations remain elevated, as indicated by the RBI’s inflation expectations survey of households.
  • 5] Interest rate hike in the US: The aggressive stance of the US Federal Reserve and ensuing tightening financial conditions.
  • India is better placed today than in 2013 to face the Fed’s actions with a stronger forex shield.

How US Fed’s actions affect India?

  • India is not insulated.
  • Capital outflow: The headwinds now are stronger than in 2013 and we have seen net capital outflows since October 2021.
  • S&P Global expects the US federal funds rate to be hiked to 3-3.25 per cent in 2023, higher than the pre-pandemic level, and highest since early 2008.
  • Despite a strong forex hoard, the RBI has had to deploy monetary policy to mute the impact of the Fed’s actions.

Inflation and its impact

  • Upward pressure on food inflation: The pressure on food inflation has increased owing to the impact of the freak heatwave on wheat, tomatoes and mangoes, which is driving prices higher.
  • This is on top of rising input costs for agricultural production, the global surge in food prices and the expected sharper than usual rise in minimum support price.
  • Fuel inflation will remain high, duty cuts notwithstanding, as global crude prices remain volatile at elevated levels.
  • Core inflation, the barometer of demand, is a complex story.
  • Goods (despite only partial pass-through of input costs) are witnessing higher inflation than services.
  • That’s because services faced tighter restrictions during the Covid-19 waves, restricting their consumption and the pricing power of providers as well.
  • Service categories that are mostly regulated, such as public transport, railways, water and education, have over 50 per cent weight in core services.
  • However, prices of discretionary services such as airlines, cinema, lodging and other entertainment are rising.
  • Transportation-related services have seen the sharpest rise in the past six months due to fuel price increases.
  • Impact on the poor: For those at the bottom of the pyramid, high inflation hits harder because energy and food are a big chunk of their consumption basket.

Growth prospects

  • S&P Global has recently cut the growth outlook for major economies for 2022 — that of the US to 2.4 per cent from 3.2 per cent, for Eurozone to 2.7 per cent from 3.3 per cent earlier, and for China to 4.2 per cent from 4.9 per cent.
  • This will hurt exports which are very sensitive to global demand.

Monetary policy actions

  • Not all aspects of supply-driven inflation can be addressed via monetary policy.
  • So the authorities are complementing monetary policy actions by using the limited fiscal space to cut duties and extend subsidies to the vulnerable.

Conclusion

Monetary tightening impacts growth with a lag of at least 3-4 quarters and the fact that real interest rates are negative and borrowing rates still below pre-pandemic levels, implies monetary policy is unlikely to be growth-restrictive for this year.

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