The cost of living is rising rapidly across the world. However, the extent of the problem is not the same in all countries. The dispersion of price pressures should be seen not just in terms of headline numbers, but also the distance of the latest inflation readings from the official or implicit inflation targets in those economies. Inflation has drifted far away from inflation targets in major Western economies such as the US, UK, Germany, Spain, Canada and Belgium. Many Asian countries actually have lower inflation than the former group right now—for example, Japan, Indonesia, Malaysia, the Philippines, South Korea and Taiwan.
The latest monthly inflation numbers in India as well as Thailand are high by regional standards, but still lower than in many rich countries. The third group consists of the countries that are anyway prone to macroeconomic scares: Turkey, Argentina, Brazil and Pakistan. Their inflation is way above global averages. And then there is China, where inflation is still not a problem, perhaps because strict lockdowns have artificially suppressed domestic demand in that country.
These varied inflation patterns mean that coordination of global monetary policy will likely come under stress, as central banks normalize policy at different speeds. Normalization includes both higher interest rates as well as withdrawal of excess liquidity from financial systems. The severity of the monetary tightening will depend on the balance of two factors. First, countries where inflation is now far ahead of the inflation target will have to move more rapidly. Two, countries where central banks have strong credibility may get away with milder reactions compared to those where trust in central banks is low.
The Reserve Bank of India (RBI) began the year with a relatively sanguine outlook on inflation. It has since moved rapidly, increasing its main policy rate by 90 basis points since the beginning of May. More rate hikes are now expected through the rest of the year. The repo rate is still 170 basis points lower than the expected average inflation for the current fiscal year.
Another way to guess the end point of the ongoing monetary tightening in India is through three sets of variables.
First, the neutral interest rate that can maintain economic growth near its potential while keeping inflation near target. Second, how the central bank estimates the gap between actual growth and potential growth on one hand, and expected inflation and its inflation target on the other. Third, the weights it assigns to the output gap and inflation gap when deciding interest rate policy.
However, interest rate policy is not all. Like its peers in other countries, RBI will have to manage its balance sheet as well. A recent note by the US Fed shows that a permanent reduction in the Fed’s holdings of 10-year US government securities equal to 1% of nominal GDP raises the term premium of a government security of the same maturity by 10 basis points. What this means is that monetary tightening has to be seen in terms of both the price of money as well as the size of the central bank’s balance sheet.
The balance sheet of RBI can then be seen in this context. The chart here shows the trend in the size of RBI’s balance sheet as a percentage of nominal gross domestic product (GDP) over the past 25 years. Fiscal year 1997-98 is a good beginning point, since that was the year RBI was freed from the requirement to automatically fund the Centre’s fiscal deficit, a change that was later strengthened in the Fiscal Responsibility and Budget Management Act of 2003.
The data shows that, other than the outlier year of fiscal 1997-98, the size of RBI’s balance sheet has ranged between 19.43% and 29.09% of nominal GDP. The number came close to the upper end of the range in 2020-21 because of three reasons: RBI bought dollars that were pouring into India at the time, it increased its holdings of government securities through open market operations in a bid to support the government’s borrowing programme at low interest rates, and nominal GDP itself slipped because of the pandemic.
The RBI balance sheet has shrunk by ₹3.3 trillion—or 1.4% of nominal GDP—since October 2021. Much of this reduction has been driven by a recent loss of foreign exchange reserves, though rupee depreciation has helped soften the impact on the central-bank balance sheet in terms of Indian currency. A smaller balance sheet, both in terms in absolute numbers as well as a proportion of nominal GDP, will impact liquidity in the domestic financial system, though that also has other drivers such as currency in circulation and government cash balances with the central bank.
In its recent Report on Currency and Finance, RBI estimates that a liquidity surplus of more than 1.52% of net time and demand deposits is inflationary; and that a 1 percentage point exogenous increase in liquidity can push up inflation by 60 basis points in a year. The upshot: both the trajectory of the repo rate as well as the way RBI manages its balance sheet will need to be watched as the fight against inflation intensifies.
Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.
