Globalisation of Inflation and Conduct of Monetary Policy
Speech by Shri Shaktikanta Das, Governor,
Reserve Bank of India
Delivered at the Kautilya Economic Conclave, organised by
Institute of Economic Growth in New Delhi on July 9, 2022
I am delighted to participate in the inaugural Kautilya Economic
Conclave. I look forward to this forum emerging as a leading platform for
thoughtful discussions on contemporary economic and policy issues. The
conference is being attended by a host of dignitaries from India and
abroad, and I am sure their insights on a vast canvas of topics will
enhance our understanding of current and future issues. In my address
today, I propose to focus on a matter that is now in everyone's mind,
ranging from the general public to policy makers in India and across the
world, i.e., inflation.
2. The global economy is going through an extremely uncertain period
amidst the simultaneous interplay of various headwinds - a lingering war
and enduring COVID; the sharp rise in energy and other commodity
prices; strains in global supply chains; and worsening food security. In
several economies, inflation is ruling at levels not seen by the recent
generations. Parallels are being drawn with the inflation era of the 1970s.
Inflation is running well above targets for a prolonged period and
threatening to unhinge inflation expectations. Central banks have begun
delivering bigger and quicker policy rate hikes to restore price stability,
even as the global economy is struggling to recover fully from the scars
inflicted by the COVID-19 pandemic. The sharply tightening financial
conditions due to the ongoing monetary policy normalisation on the one
hand and the persisting geopolitical tensions on the other pose significant
downside risks to near-term global economic prospects. They are also
sparking stagflation concerns worldwide, with even talk of recession in
some parts of the world.
Globalisation and Inflation
3. Over the years, globalisation of trade and capital flows had
facilitated increased productivity and lower cost of tradeable goods and
services. With access to information, communication and transportation
technology and the advent of multinational companies, production hubs
proliferated at multiple locations, leading to the emergence of global value
chains. Globalisation also fostered competition, efficiency and innovation.
Increased flow of trade, know-how, people and ideas bridged the
technology gap, improved institutional capacity and accelerated the
accumulation of physical and human capital in emerging markets. The
result was higher growth and lifting of millions out of poverty.
4. More importantly, globalisation-led productivity gains contributed to
a trend decline of inflation across countries. More and more countries,
including emerging market economies (EMEs), strengthened their
monetary policy frameworks with a number of them adopting inflation
targeting. There was growing talk of globalisation leading to sustained
disinflationary forces, technology diffusion and competition. We witnessed
low and stable inflation in advanced economies (AEs) and several EMEs
beginning the 1990s and through the second decade of the new
millennium.
5. With greater trade and financial integration, the domestic economies
get more exposed to global shocks including volatile short-term capital
flows. For instance, global shocks to food, energy and commodity prices
affect inflation in every country. During the COVID-19 pandemic and now
due to the war in Europe, there are clear signs of transmission of global
shocks to generalised and synchronised inflation across the world.
6. The recent upsurge in inflation due to the black swan event, i.e., the
war in Europe, on top of another such event, i.e., the Covid-19 pandemic
offers a classic example of the globalised nature of current inflation.
Around 77 per cent of countries reported acceleration in inflation in 2021
and this proportion is expected to rise further to 90 per cent in 2022,
according to the IMF's latest projections. Moreover, for advanced
economies, against an inflation target of 2 per cent, and emerging market
economies, against an average target of about 3-5 per cent, two-thirds
are witnessing inflation above 7 per cent1. While global factors have
always been an important driver of domestic inflation, what we have
witnessed over the past three years is the more protracted and sizeable
role of global factors in proportions not witnessed in decades. These
factors have an even more conspicuous effect on net commodity
importing countries like India.
7. With the origins of this inflation being essentially in the supply side,
energy and food prices account for more than 50 per cent of the rise in
prices. There are also increasing signs of sectoral price spillovers, given
that the rise in global energy and commodity prices quickly translate into
higher input price pressures. While in some advanced economies, pricing
power of firms has increased significantly due to strong domestic demand
since 2021, other advanced economies and emerging market economies
have just started experiencing such pressures beginning 2022.
Household inflation expectations have started firming up, though they are
not severely unanchored at this stage. Overall, we are now living in an era
of globalisation of inflation amidst growing deglobalisation of world trade.
8. The persistence of inflation at elevated levels has also raised the
debate as to whether the much required monetary actions to contain
inflation will end in hard landing (a global recession) or will the monetary
authorities be able to manage soft landing (a moderation in inflation closer
to targets with only a moderate slowdown in output growth). Analysts point
to the track record of the US economy. Ever since the data on the Federal
Funds rate are available from Q3:1954, there have been ten occasions in
which monetary tightening has caused a recession in the US. On the other
hand, not all episodes of tightening have ended in recession. In the
present context, let us look at the evidence available so far. First,
revisions in GDP projections by major central banks and multilateral
agencies in June 2022 continue to indicate a loss of pace rather than a
loss of level. Second, with front-loaded monetary policy actions underway,
central banks may not face the need for prolonged actions that lead to
recessions, by historical experience. Third, with the labour participation
rate still lower than pre-pandemic levels in US and UK, wage pressures
are rising but not yet overheated. Finally, food and fuel price pressures
are essentially transitory and may ease sooner or later, taking out a large
contributor to currently elevated inflation. The evolving trends need close
monitoring.
Historical Perspective
9. The current synchronised rise in inflation across economies is not a
maiden occurrence in modern economic history. Let us step back in time
and recount what had happened during the inflation era of the 1970s.
Amidst repeated supply shocks from oil prices in 1973 and 1979-80 and
weather-related food shocks, countries were mired in stagflation with
double digit inflation accompanying a rise in unemployment.
10. The experience of the 1970s significantly changed the course of
macroeconomic thinking. Policymakers understood that there is no
permanent trade-off between inflation and output - any attempt to
increase output at the cost of tolerating higher inflation will inevitably lead
to high and rising inflation and unhinging of inflation expectations without
any durable output gains. This realisation led to a growing focus on
keeping inflation expectations well-anchored and strengthening of
monetary policy frameworks, including adoption of flexible inflation
targeting. During the subsequent period, inflation and inflation volatility
declined remarkably, inflation expectations gradually aligned with the
target across economies, and the global economy expanded on a steady
path, leading to an era described as the Great Moderation (Bernanke,
2004)2. Inflation spikes also became short-lived, given well anchored
inflation expectations. While improved monetary policy frameworks did
play an important role, the concomitant rise of rule-based fiscal policies
backed by fiscal responsibility legislations, gains in productivity and
technology, deepening of financial systems and globalisation also helped
in moderating inflation.
Inflation and the Conduct of Monetary Policy in India
11. The history of inflation in India since independence (1947) reveals
that incidents of high and volatile inflation mainly emanated from droughts;
wars; trends in minimum support prices (MSPs); global crude oil price
shocks; large fiscal deficits and their monetisation; and sharp exchange
rate movements. Overall, while there were sporadic occurrences of high
inflation, the Indian economy did not encounter episodes of hyperinflation.
12. The Gulf War of 1991 - which resulted in a spike in international
crude prices and consequent increase in domestic administered prices -
was a major episode of imported inflation. In addition, the balance of
payments (BoP) crisis of 1991 led to sharp exchange rate devaluation,
which translated into increased cost-push pressures on import sensitive
products. Beginning the second half of the 1990s, the improvement in
fiscal-monetary interface and reforms in the Government securities
market provided monetary policy the operational flexibility to deliver on its
price stability and growth objectives.
13. The next major inflation shock was in the post-GFC period when
monsoon failure, high increase in MSPs, and escalating global commodity
prices triggered inflationary pressures, which were reinforced by demand
pull from a quick rebound in domestic growth from monetary and fiscal
stimulus measures. Monetary policy normalisation at that time was
gradual, given the considerations of economic recovery. With signs of
inflationary pressures getting entrenched, monetary policy moved to an
aggressive tightening mode in 2011. By 2013, macro-imbalances began
to build up and got reflected in high and persistent inflation, growth
slowdown and a deteriorating external sector. In this scenario, the taper
tantrum of 2013 plunged the economy into severe external sector stress
and macro-financial vulnerabilities. These developments set in motion the
process towards the formal adoption of a flexible inflation targeting (FIT)
framework for monetary policy in June 2016.
14. What followed was a period of low and stable inflation till the COVID
shock. The average CPI inflation between September 2016 and February
2020 was 3.9 per cent and was closely aligned with the inflation target of
4 per cent.
Recent Phase
15. The onset of the pandemic in early 2020 saw global commodity
prices crash as restrictions and stringent lockdowns were expected to lead
to a collapse of aggregate demand. There were, however, two occasions
during the calendar years 2020 and 2021 when inflation hovered above
6.0 per cent. First, from June till November 2020 when the surge in
inflation was trigged by a series of adverse transitory supply side shocks
ranging from increase in retail margins in food items; supply chain and
logistics bottlenecks; unseasonal rains and resultant crop damage; and
the domestic spillovers from the sharp rise in international prices of edible
oils. In the following period, that is from December 2020 to April 2021,
inflation moved closer to the target rate of 4 per cent as much of the
transitory price shocks waned. The easing of inflationary pressures,
however, was short-lived as India experienced a devastating second wave
of COVID-19 during April-June 2021 which triggered localised lockdowns,
renewed supply chain disruptions and rising retail margins. This pushed
inflation above 6.0 per cent during May-June 2021. The inflation pressures
were reinforced by adverse spillovers from rising global commodity prices.
16. The inflationary pressures occurred even as there was
unprecedented damage inflicted by the pandemic on economic activity -
real GDP contracted by a humungous 23.8 per cent in the first quarter of
2020-21 and by as much as 6.6 per cent in the full financial year 2020-21.
Against this backdrop, the monetary policy committee (MPC) of the RBI
maintained status quo on rates during the pandemic despite inflation
intermittently breaching the upper tolerance band. The MPC decided to
look through the higher inflation print to allow the nascent recovery to get
entrenched - both by retaining the accommodative stance of policy and
by refraining from hiking the policy rate. Since the inflationary episode
lacked any significant demand-pull component, any policy tightening at
that juncture would have been detrimental to growth and extracted heavy
social costs without being effective in containing inflation pressures. This
was in consonance with the flexibility embedded in our flexible inflation
targeting framework, according to which the primary objective of the
monetary policy is to maintain price stability while keeping in mind the
objective of growth.
17. In early 2022, inflation was expected to moderate significantly to the
target rate of 4 per cent by Q3:2022-23, with a projected average inflation
rate of 4.5 per cent for 2022-23. This assessment was based on an
anticipated normalisation of supply chains, the gradual ebbing of COVID-
19 infections and a normal monsoon. The median inflation projection from
the Survey of Professional Forecasters at 5.0 per cent for 2022-23 was
also quite benign. This narrative was, however, completely overtaken by
the war in Europe since end-February, which led to a sharp spike in global
crude oil and other commodity prices. Global food prices reached a
historical high in March and their effects were felt in edible oil, feed cost
and domestic wheat prices. The loss of Rabi wheat production due to an
unprecedented heat wave put further pressures on wheat prices. Cost-
push pressures were also aggravated by supply chain and logistics
bottlenecks due to the war and sanctions.
18. Taking stock of the evolving developments and with inflation
pressures getting generalised, the MPC in its April and June meetings
revised the projection of inflation for 2022-23 in two stages to 6.7 per cent.
About three-fourths of the revision in June was on account of geopolitical
spillovers to food prices. The MPC also decided to increase the policy
repo rate by 40 bps and 50 bps in May and June, respectively. This was
on top of the 40 bps effective rate hike through the introduction of the
Standing Deposit Facility (SDF) at 3.75 per cent, which resulted in a
concomitant increase in the weighted average call rate (WACR),
compared to the liquidity absorption rate under the fixed rate reverse repo
regime. The WACR, as you would be aware, is the operating target of
monetary policy. During this period, i.e., April to June 2022, the MPC also
changed its stance to withdrawal of accommodation.
19. Overall, at this point of time, with the supply outlook appearing
favourable and several high frequency indicators pointing to resilience of
the recovery in the first quarter (April-June) of 2022-23, our current
assessment is that inflation may ease gradually in the second half of
2022-23, precluding the chances of a hard landing in India.
Approach to Monetary Policy in Crisis Times
20. A closer look at our journey through the two black swan events of
COVID-19 and the geopolitical crisis in Europe would bring out certain
distinct contours of our approach in these turbulent times. Our overarching
objective was to safeguard the economy and preserve financial stability.
Our endeavour has been to ensure a soft landing. These objectives
continue to guide our actions even today and it will continue to be so in
future. I would now like to touch upon a few aspects of our approach.
Communication in Turbulent Times
21. For monetary policy to be effective in such turbulent and uncertain
times, communication of monetary policy objectives, actions and stance
with prescience and clarity assumes even greater importance. Monetary
policy is ultimately about managing expectations of various economic
agents - from households to financial markets. In this context, over the
past three years, we backed our actions with clear forward guidance and
tweaked it as necessary with reference to the evolving circumstances. For
instance, our forward guidance was initially state-based. But, in the
second half of 2020-21, there were undue market concerns that the
accommodative monetary policy stance might have to be reversed in the
face of elevated inflation. To quell such disruptive forces and their possible
negative effects on our accommodative stance, we supplemented our
state-based guidance with time-contingent guidance by stating our intent
to continue "with the accommodative stance of monetary policy as long as
necessary - at least during the current financial year and into the next
year ...". Inflation eased in the second half of 2020-21 itself in line with our
assessment as supply side pressures abated. The time-based element of
the guidance did help to anchor market expectations and moderate undue
expectations building up at that time of a possible reversal of the monetary
policy stance.
22. We have actively engaged in two-way communications - we consult
actively with various stakeholders in the run up to the bi-monthly MPC
meetings; we hold wide ranging press conferences after the bi-monthly
meetings to put forward our viewpoints clearly and clarify the issues raised
by the media and analysts. We back up this with speeches and media
interviews. The release of the minutes after 14 days of the MPC meeting
and individual statements of the members, including my statement, have
further strengthened our communication. A range of statutory and staff
publications on key analytical aspects of monetary economics are an
additional avenue of our forward-looking communication.
23. My regular statements to announce the MPC decision and its
rationale have become an integral element of the institutional edifice of
the RBI's crisis time response. These statements provide forward
guidance to financial markets on the RBI's liquidity stance and have
ensured orderly conditions in the financial markets, even amidst the
pandemic and war related stress. In August 6, 2021 statement, I
emphasised that the RBI remains in "whatever it takes" mode, with a
readiness to deploy all its policy levers - monetary, prudential or
regulatory. These words engendered calm and confidence in the markets.
Prudence as the Cornerstone of our Approach
24. During this entire period, we had gone beyond the rule book and we
had explicitly said so. But we remained prudent at all times. For example,
when we announced the government securities acquisition programme
(G-SAP) in April 2021, we were going beyond the RBI's lexicon; but we
discontinued it after six months when liquidity was assessed to be amply
surplus. By doing so, we were well ahead of the major central banks in
ceasing fresh asset purchases. Similarly, we refrained throughout the
pandemic period from primary financing or direct monetisation of the
government's fiscal deficit, notwithstanding the clamour from various
expert opinions at that time. Prudence also underlined our approach when
we refrained from diluting the quality of the RBI's balance sheet by strictly
confining our liquidity injection measures to government securities as
collateral. Further, the Resolution Frameworks for COVID-19 related
stressed assets were not open ended, but were subject to certain financial
and operational parameters to be achieved as part of the resolution
process.
Conventional, Unconventional and Innovative Measures
25. As I said a little while ago, we have often gone beyond the rule-book
over the past 2-3 years, combining conventional, unconventional and
innovative measures. For instance, we made active use of the Liquidity
Adjustment Facility (LAF) corridor as an instrument of policy, first through
large reductions in the reverse repo rate in March and April 2020.
Consequently, the money market rates went even below the policy rate.
Another such example was in April 2022 with the institution of the
Standing Deposit Facility (SDF) at 40 basis points above the fixed rate
reverse repo to begin the process of withdrawal of the accommodative
stance. There are other such examples of being nimble-footed like the
advancement of MPC meetings, the off-cycle MPC meetings, etc.
Navigating the Liquidity 'Chakravyuh'3
26. Our liquidity injection measures involved a prudent and calibrated
expansion of the RBI's balance sheet. Our measures were targeted as
per requirement and reflected a hands-on approach. These would include
the targeted long term repo operations (TLTROs); special liquidity
windows to support contact-intensive sectors severely hit by the
pandemic; reduction in the Cash Reserve Ratio (CRR) for a limited and
pre-specified period; and a few other measures. We had explicit sunset
clauses for most of our liquidity injection measures during the pandemic
which allowed us to unwind liquidity in a predictable manner and anchor
market expectations. By building in the exit strategy at the time of
injection, we were able to pull out significant part of the liquidity when it
was no longer required.
27. We started rebalancing of liquidity as early as January 2021 through
the reintroduction of variable rate reverse repos (VRRR) to shift liquidity
from the overnight fixed rate window towards longer tenors at variable
rates. This helped in pushing market rates upwards in a gradual and
orderly manner. This is an example of what I would call a silent action,
preparing and guiding the markets in advance.
Concluding Observations
28. The benefits of globalisation come with certain risks and challenges.
Shocks to prices of food, energy, commodities and critical inputs are
transmitted across the world through complex supply chains. This was
evident during the pandemic, and more so after the conflict in Europe
erupted, with global shocks playing a dominant role in domestic inflation
dynamics. These global factors present difficult policy trade-offs between
price stability and stabilising economic activity, especially when the
economy is recuperating from repeated shocks. They add to the
macroeconomic and financial stability challenges from volatile capital
flows in a financially globalised world. In fact, recent developments call for
greater recognition of global factors in domestic inflation dynamics and
macroeconomic developments which underscore the need for enhanced
policy coordination and dialogue among countries to achieve better
outcomes.
29. The insurance against such inevitable global shocks ultimately is
built on sound economic fundamentals, strong institutions and smart
policies. Price stability is key to maintaining macroeconomic and financial
stability. In a broader sense, inflation is a measure of the trust and
confidence that the public repose in the economic institutions of a country.
While factors beyond our control may affect inflation in the short run, its
trajectory over the medium-term is determined by monetary policy.
Therefore, monetary policy must take timely actions to anchor inflation
and inflation expectations so as to place the economy on a strong and
sustainable growth pedestal. We will continue to calibrate our policies with
the overarching goal of preserving and fostering macroeconomic stability.
In this endeavour, we will remain flexible in our approach while being
cogent and transparent in our communication. If history is any guide, I am
optimistic that our actions will usher in a new era of prosperity in the years
ahead.
Thank you.