Soaring Inflation: What It Means For Central banks, The Economy and The Consumers
At its off-cycle Monetary Policy Committee meeting on 04 May 2022, the RBI surprised the market with a 40-bps rate hike changing its policy stance and further hiking the rate in June 2022. As a result, the policy discourse has changed after COVID stuck year (FY2022).
The inflation has worsened due to tensions between Ukraine and Russia. The scenario is same across the globe. As of June 2022, inflation in the U.S. was 9.1%, up from 8.3% in April 2022. There is a similar situation in almost every country with inflation rocketing to 9.4% in June 2022 in the United Kingdom. As a result, interest rates have been raised in many countries, including the U.S., the UK, India, and the Eurozone. Inflation, geopolitical tensions, and monetary tightening now threaten the world economy's recovery. U.S. GDP has already fallen by 1.6% in the first quarter of 2022.
In India, inflation breached the RBI's comfort zone in January 2022, reaching 7.79% in April 2022. The RBI raised the Repo rate in response to rising inflation and monetary tightening by other central banks. While geopolitical tensions have little impact on the economy with most high frequency indicators of demand in the green zone, the Indian economy may be affected by a combination of monetary and geopolitical forces in the coming months.
The Four Quarters of FY2022 -
Due to large monetary and fiscal policy supports and the vaccination drive, the global economy recovered from the COVID-19 pandemic. Nevertheless, the impact was palpable. The price of crude and base metals has increased, especially since the beginning of the year and Inflationary pressures caused supply constraints. Globally, the Delta variant of COVID-19 and sticky inflation contributed to uneven recovery in the first half of 2022.
"While geopolitical tensions have little impact on the economy with most high frequency indicators of demand in the green zone, the Indian economy may be affected by a combination of monetary and geopolitical forces in the coming months."
The global economy had regained some traction after the shock of delta variant in the first half of 2021. Global economic prospects deteriorated significantly in the second half of 2021 and initial months of 2022 due to the new variant of COVID - Omicron, Ukrainian and Russian tensions, and the resulting sanctions. Global growth is expected to decline from 6.1% in 2021 to 3.2% in 2022 as a result of the shock of the war and monetary tightening, financial market volatility, pandemic and unequal vaccine access.
FY 2022 began on a positive note for India, with favourable macroeconomic shifts pointing towards a recovery in the economy and inflation returning to the RBI's comfort zone. In the aftermath of a very difficult FY 2021, which changed the world forever, people breathed a sigh of relief. In the last quarter of the FY 2021 and FY 2022, India turned the crisis into an opportunity and adopted the mantra of Aatmanirbhar which became the cornerstone of our growth strategy.
With the devastating second wave, FY2022 was something of a roller coaster. Most high frequency indicators showed COVID-19 causing havoc in April 2021 A reddish hue appeared during that month, which faded by June 2021. Despite GST e waybill generation slowdown in January 2022, the impact of Omicron variant was mild, as demonstrated by two-wheeler sales, tractor sales data. The outlook for FY 2023 is uncertain due to geopolitical tensions, inflation, and monetary tightening around the world.
The Global Factor -
A vaccination drive had brightened recovery prospects across the globe following a year of uncertainty surrounding the COVID-19 outbreak. In 2021, world output expanded by 5.9% after contracting by 3.1% in 2020.
Several countries have experienced longer-than-expected supply disruptions due to delta variant outbreaks. As a result, the supply chain was further stressed, leading to higher inflation around the world. Through 2021 and 2022, inflation in the USA exceeded the target level of 2%. In the Euro area as well as other countries around the world, the situation is pretty much the same.
The U.S. inflation rate spiked to 4.2% in April 2021, the highest since September 2008. Globally, this led to elevated inflation not just in the USA but across most countries, causing dilemmas among policy makers regarding the nature of inflation (transient or not) and the timing of reversing expansionary policies. Geopolitical tensions following the Omicron outbreak have further exacerbated inflationary pressures. The U.S. inflation rate reached 9.1% in June 2022, up from 5.4% in July 2021. Although policy makers around the globe have implemented expansive policies in order to assist economic recovery, persistent inflationary pressures have compelled them to propose policy normalization. As a result of the COVID pandemic, the Federal Reserve raised its benchmark interest rate by 25 basis points in March 2022, followed by 50 basis points in May 2022 and 75 basis points in June 2022.
Many central banks have hiked interest rates in recent years to tame inflation, including the Bank of England, which has done so five times in a row since December 2021. It is evident that the shock of the war, coupled with monetary tightening, financial market volatility, and the pandemic and unequal access to vaccines will have a lasting impact on the world economy.
Due to the increase in interest rates in the USA, the dollar has appreciated against all currencies except the Russian Rouble. The Dollar Index reached 100 in May 2022 and has been steadily increasing since then. As a result of this increase, inflation will be exported to other countries through the depreciation of their currencies. Rate hikes are expected to slow down economic recovery and have sparked fears of stagflation around the world. Over the next few months, these global factors will continue to have an impact on the Indian economy.
The Great Indian Rebound -
After contracting by 4.8% in FY 2021, the Indian economy rebounded by 8.1% in FY 2022. After the pandemic, the Indian economy recovered to its pre-pandemic level. It was mainly due to the concerted efforts of monetary and fiscal policymakers, with liquidity enhancement and Aatma Nirbhar reforms and package playing a significant role.
In comparison with other countries, India's response to the pandemic and lockdown was relatively light on fiscal measures.
During the first lockdown in 2020, the Government of India announced a package of 20 lakh crores to stimulate the economy. The government's policy response was to direct credit to small businesses and individuals and to boost capital expenditure. During a normal recession, policy's role is to raise aggregate demand and output consistent with full utilization of resources. In the event of a pandemic-induced recession, policy responses are dependent on the state of the public healthcare system. In an uncertain environment due to the virus, large cash transfers may not lead to a higher level of spending. If they do, supply chain disruptions can lead to inflation.
"During the first lockdown in 2020, the Government of India announced a package of 20 lakh crores to stimulate the economy. The government's policy response was to direct credit to small businesses and individuals and to boost capital expenditure."
There were a variety of sections included in the 'AatmaNirbharBharat' package, including migrant workers, the agriculture sector, micro, small and medium enterprises, and street vendors. It involved frontloading transfers to farmers and distributing free food grains. Production-linked incentives were subsequently implemented to boost India's manufacturing sector. India's economic recovery has relied heavily on this sector.
In April 2021, we witnessed the outbreak of the second wave of COVID-19 and its devastating impact on millions of lives and livelihoods. As a result of localised lockdowns and a higher vaccination rate in the country, the Indian economy maintained the growth momentum it had established in the last quarter of FY 2021, and GVA at basic prices increased by 18.1% in the first quarter of FY 2022. In the second and third quarters of FY 2022, the Indian economy gradually grew as the deadly Delta variant-induced second wave waned.
The highly transmissible Omicron variant led to an increase in COVID cases in the last quarter of FY 2022, but the mild nature of the disease and its sudden downturn did not adversely affect the economy. In terms of the impact of the war, the Indian economy has remained resilient so far due to its own macro-fundamentals. While GVA growth from October-December 2021 to January-March 2022 slowed - bringing the annual growth in FY 2022 to 8.7% from 8.9% in NSO's second advance estimates - recent high-frequency indicators of economic activity indicate that momentum has picked up in FY 2023 across a wide range of sectors.
High frequency data corroborate our reading of quarterly GVA data and provide a more detailed picture of the economy's recovery and the impact of COVID-19's second and third waves.
In the month of April 2021, we saw a decline in many indicators such as Domestic tractor sales (-25.5%), GST eway bill (-17.5%), and Two-wheeler sales (-33.5%) which were influenced by Delta variants in the country.
According to the positive high frequency data indicators, the impact has largely passed by June 2022.
There was less death from Omicron variant than Delta variant, and it did not adversely affect the economy as much as the second wave (induced by Delta variant). In the month of January 2022, passenger car sales (12.2%), two-wheeler sales (12.2%) and other similar indicators confirm this.
Most indicators were in green in March 2022 despite the tense geopolitical situation, especially domestic tractor sales which increased by almost 40%. However, we did see a drop in e-way generation in May and June 2022, resulting in a plateauing of GST collections. Domestic two-wheeler sales have crossed pre-pandemic levels, and domestic tractor sales remain robust due to the success of Rabi crops.
The demand for farm labour has increased in June 2022 due to Kharif crop sowing in rural areas of the country and the consequent increase in demand for farm labour under MGNREGA.
For 11 consecutive months, the Purchasing Managers' Index (PMI) of the manufacturing sector has remained above the benchmark of 50 in FY 2021-22. PMI records above the mark of 50 in April and May 2021 reflect the localized nature of lockdown following COVID-19. Also in January 2022, the economy remained positive.
While PMI services shrank in May-July 2021, the touch sensitive service sector was left reeling in the wake of second wave lockdowns in the states.
In June 2022, PMI services expanded at the fastest pace in over 11 years, growing to 59.2 from 58.9 in May 2022.
At the beginning of the FY 2022, the Indian unemployment rate, which skyrocketed to 23.5% in March 2021 due to COVID-19, dropped to single digits. Despite the COVID-19's second wave in April and May of 2021 resulting in an increase in unemployment, it eventually declined to its pre-second wave level by July 2021. It remained around 6-7% through FY 2022, indicating that the economy has gradually recovered and is becoming more open, especially the touch sensitive services sector.
A major indicator of employment generation in the economy is the Labour Force Participation Rate (LFPR). If the same continues to fall, it will lead to low employment generation and people dropping out of the workforce. The number has been below 40 since January 2022. According to this, the recovery from the pandemic has been uneven. Since then, the LFPR has remained below 40 and reached the lowest level in a year in June 2022. Using this indicator, we can see that unemployment levels are higher than those reflected in Trends in Inflation-Expectations and Realities. India's inflation rate, which breached 6% for most of FY 2021, remained range-bound in half of FY 2022. In 2021, both developed and developing countries experienced elevated inflation as a result of pandemic-related disruptions in supply and logistics, a rebound in global commodity prices, and a release of pent-up demand.
As a result of localised lockdowns induced by COVID-19's second wave, headline inflation in India reached the upper tolerance level of the inflation target, causing a sharp increase in inflation in all three major groups - food, fuel, and core - during May-June 2021.
Food and beverage inflation continued to drive headline inflation in FY 2022, although its contribution to headline inflation decreased from 54.8% a year earlier to 35.9%. A sharp rise in the price of liquefied petroleum gas (LPG) and kerosene in October 2021 resulted in a negative shift in food and beverage inflation over headline inflation during the second quarter of FY 2022 as fuel prices scaled new peaks and reached an all-time high of 14.3%.
The headline inflation rate remained well within the target limit of 4 +/- 2 percentage points until the start of Q4 FY 2022. As a result of increased supply side bottlenecks, coupled with the tense geopolitical situation as a result of Russia-Ukraine tensions, commodity prices have been on the rise. Between February 25 and March 29, 2022, the Indian basket of crude oil averaged $111.86 per barrel, according to the Petroleum Planning and Analysis Cell (PPAC). In May 2022, headline inflation declined to 7.04% from 7.79% in April 2022. As a result, inflation appeared to have peaked in May 2022. The government has taken a number of measures to curb inflation. By reducing indirect taxes on fuel, fiscal measures have directly contributed to lower inflation in May 2022.
It was in May 2022, the Central Government reduced excise duty on petrol by Rs 8 per litre and on diesel by Rs 6 per litre. Customs duty on raw materials for steel and plastic was also reduced. Due to this measures, the price of petrol fell by 2.4% while that of diesel dropped by 2%. As the result of duty reduction, the prices of fuels were lower in June compared to May 2022. These measures have helped to bring down CPI to 7.01% in June 2022.
If one observes the inflation trend, it is evident that urban inflation has been higher than rural inflation by 0.8 percentage points throughout 2021. August was the month of exception when both, urban and rural inflation, stood at 5.3%.
However, for most of the months in FY22, the core inflation has been higher than headline inflation. This tells a lot about the structural nature of inflation. The price rise was seen even in non-food segments like clothing, health, transport etc. This means that manufacturers are passing the higher cost to the consumer. It is to be noted that throughout FY22, the inflation at the wholesale level remained in double-digit territory. In general, wholesale inflation is lower than headline inflation, but starting March 2021, this pattern has reversed. Since March 2021, the difference between headline and wholesale inflation has been 7.3% on average. The reason could be that wholesalers are not fully passing on the price increase to retailers. This phenomenon is known as "Inflation-in-the-pipeline." It is very likely that these price shocks will eventually be passed on to the ultimate consumers.
Interest Rate Movement -
Extreme risk aversion and increased volatility in the financial markets were brought on by the COVID-19 pandemic. The goal of monetary policy and liquidity operations in FY 2021 was to lessen the negative effects of the COVID-19 pandemic's catastrophic economic destruction on the Indian economy. Between March and May 2020, the Monetary Policy Committee (MPC) reduced the policy repo rate by 115 bps. These initiatives, supported by both traditional and non-traditional liquidity measures, helped to maintain orderly market conditions while boosting mood in the financial markets. In all market categories, interest rates and bond yields fell in FY 2021, thereby shrinking the spreads.
"This means that manufacturers are passing the higher cost to the consumer. It is to be noted that throughout FY22, the inflation at the wholesale level remained in double-digit territory"
In an effort to keep bond rates in control and keep the government's borrowing costs low, securities worth $1 Trillion were sold in open market operations in the first quarter of FY 2022. The benchmark 10 year government bond received support from this. The 10 year G-Sec yield traded between 5.96-6.10% during the quarter to conclude at 6.05%.
Due to monetary tightening in the United States and India in the first quarter of FY 2022-23, yields increased even more. By the end of June 2022, yields had toughened to 7.45%. Since core components are now being affected by inflation, the Federal Reserve may raise rates again in September 2022, which could cause government bond yields to increase globally.
The Implications For The World Economy -
As recently as a few months ago, central banks anticipated that they could tighten monetary policy fairly gradually. The pandemic related shocks and Russia's invasion of Ukraine appeared to be the primary cause of inflation, which was predicted to fall quickly after these pressures subsided.
As pricing pressures spread to housing and other services and inflation rises to multi-decade highs, central banks are now aware of the need to act more quickly in order to prevent an unmooring of inflation expectations and tarnishing their credibility. To avoid future adjustments that could be much more difficult and disruptive. Policymakers should take note of the lessons learned from the past and act decisively.
Interest rates have already been sharply increased by the Federal Reserve, Bank of Canada and Bank of England, and all have indicated they expect to continue raising them this year. For the first time in more than ten years, the European Central Bank just increased interest rates.
The current fiscal and monetary tightening should reduce demand for both energy and non-energy related goods, particularly in interest sensitive sectors like consumer durables. In the absence of more disruptions in the commodities markets, this should result in a slower or even negative increase in the price of products. It may also result in a negative increase in the price of energy. As the epidemic loosens its grip and lockdowns and production interruptions become less common, supply-side pressures should diminish.
However, the central banks and markets were taken aback by how quickly inflation soared, and the future of inflation is still very uncertain. If supply chain disruptions subside and global policy tightening leads to swift drops in energy and commodities prices, inflation may reduce more swiftly than central banks anticipate.
However, inflation risks still seem to be heavily skewed to the upside. There is a significant chance that high inflation will stick around and inflation expectations will drift.
The rate of inflation in the services sector - for everything from housing rents to personal services-seems to be increasing from already high levels, and it is unlikely that it will decline soon. Rapid nominal wage increases might make these pressures worse. In nations with robust labour markets, nominal salaries may begin to rise quickly, more quickly than what businesses could realistically absorb, with the ensuing increase in unit labour costs being passed on to consumers as higher prices. Such "second round impacts" would result in higher inflation expectations and more sustained inflation. Finally, a prolonged period of high inflation may result from a further escalation of geopolitical tensions that sparks a new increase in energy costs or exacerbates current problems.
Markets appear to be placing large odds on the likelihood that inflation may rise over central bank targets over the coming years, despite the market-based information on "average" inflation forecasts outlined above appearing to be encouraging. Markets indicate a substantial likelihood that inflation rates of over 3 percent will continue in the US, the euro region, and the UK in the upcoming years. The most likely scenario is one of moderate global growth in late 2022 and early 2023.
High inflation keeps putting a strain on family budgets and eroding consumer confidence. While this is happening, the post-pandemic boom in tourism and consumer services is starting to slow down. In the coming year, investment and consumer durables spending will be constrained by the lag effects of tighter monetary policy and rising interest rates. Thus, it is anticipated that global real GDP growth will drop from 5.8% in 2021 to 2.7% in 2022 and 2.3% in 2023. Global growth is anticipated to rebound to 3.0% in 2024 as inflation declines and financial conditions improve. The key to the prediction of a soft landing is a slowdown in price and wage inflation.
In light of the current economic climate, a global "soft landing" would be indicated by a decline in input and output price inflation, a stabilization of labour markets, and efficiently operating financial markets. Recent drops in the price of industrial and agricultural commodities are beneficial for the fight against inflation. The IHS Markit Materials Price Index has decreased 20% since its early March peak as of mid-August. Due in major part to sluggish demand from mainland China, crude oil prices have fallen below $100 per barrel. Consumers in most regions of the world should feel some comfort as a result of the decline in commodity prices as it is transferring downstream to intermediate and finished goods. Global consumer price inflation is predicted to decline to 4.5% in 2023 and 2.6% in 2024 after increasing from 3.9% in 2021 to 7.6% in 2022. The low level of inventories in the energy and metals markets, however, might make the near-term outlook gloomier due to new supply shocks.
In turn, tighter monetary policy will be crucial in bringing inflation under control. The ability of central banks to achieve a gentle landing and hit their inflation goals without raising interest rates above the current inflation rate remains to be seen. The COVID-19 epidemic and the energy shift have affected supply in ways that have contributed significantly to the recent rise in inflation. The tightening financial conditions are essential to reducing inflation and calming excessive demand. The amount of tightness will change depending on the surroundings. The federal funds rate in the US is anticipated to increase to a range of 3.50-3.75% in December 2022 and remain there for an entire year. The European Central Bank acts more cautiously when the Eurozone enters a recession later in 2022 and raises its refinancing rate to its long-run neutral rate of 2.00% in January 2023. Emerging markets that depend on capital inflows to cover trade and fiscal deficits are at risk as a result of investors' flight to safety. Western Europe will enter a recession due to issues with the energy supply and high prices. As high inflation reduced household earnings and consumer confidence hit a record low, the UK entered a recession in the second quarter. The UK recession is anticipated to last into the first quarter of 2023, with consumer price inflation at 10.1% year over year (y/y) in July and rising (with a 75% hike in gas and electricity rate caps in October).
Due to inventory build-up and penned-up demand for services, the second quarter's real GDP growth in the Eurozone was stronger than anticipated (0.7% q/q). However, due to persistent energy supply constraints, rising costs, the on-going Russia-Ukraine conflict, and tightening financial circumstances, growth prospects are quickly eroding. Real GDP growth is anticipated to decline from 5.2% in 2021 to 2.9% in 2022 and 0.8% in 2023 due to the likelihood that the Eurozone will face a moderate recession in late 2022 and early 2023. Germany and other northern European manufacturing hubs are particularly vulnerable to interruptions in Russian energy supplies. The US economy is characterized by a contradiction of rising employment and stagnant real GDP.
Do not refer to the first two quarters of 2022's real GDP decline as a recession. The employment rate, industrial production, real personal income before transfers, and real retail sales have all increased significantly since December 2021. In the meantime, a severe slowdown in inventory growth has reduced real GDP. Our prediction anticipates a period of slow economic growth until the end of 2023, as notable losses in residential and commercial building are offset by modest increases in consumer expenditure and government purchases. Prior to increasing up to 1.7% in 2024, real GDP growth is predicted to decline from 5.7% in 2021 to 1.5% in 2022 and 1.0% in 2023. The US unemployment rate will probably increase from 3.5% in July to 4.8% in mid-2024 as a result of GDP falling short of potential.
Mainland Chinese economy is still having trouble. In China, the real GDP is anticipated to increase in the third quarter after falling 2.6% q/q in the second quarter, despite July data showing weak growth in services and manufacturing.
The dynamic zero-COVID policy of the government will continue to be in effect until at least March 2023, impeding a return to normalcy and reducing the efficacy of the government's new stimulus initiatives. The local government's finances are suffering as a result of the on-going severe downturn in the property market and decreased land sales. It is anticipated that real GDP growth will decrease from 8.1% in 2021 to 3.8% in 2022 before increasing to 4.9% in 2023.
As other regions struggle, the growing economies of Asia-Pacific will help to sustain global development. Asia Pacific's real GDP growth is anticipated to accelerate to 4.5% in 2023 after falling from 6.2% in 2021 to 3.8% in 2022. Five to seven per cent growth rates are anticipated for Bangladesh, Cambodia, Vietnam, India, Indonesia, and the Philippines. This performance is a result of robust intraregional growth dynamics brought about by regional free-trade agreements, effective supply chains, low costs, and consistent inflows of foreign direct investment.
To sum up Global inflation is anticipated to decline in 2023 and 2024 as global demand slows and supply disruptions ease. Real GDP is anticipated to average 2.5% in 2022 and 2023, signalling a soft landing for the world economy. However, this economy will have multiple speeds, and a slight recession in Western Europe is anticipated to occur in late 2022 or early 2023. Other significant nations will avoid recessions but underperform.