India must address risks to financial stability
It is now clear that the US Federal Reserve is considering reducing the pace of its asset purchase. Fed Chairman Jerome Powell in his much-anticipated address at the annual Jackson Hole symposium last week said several members of the Federal Open Market Committee (FOMC), including he himself, were of the view that the economy had evolved as expected, and it could be appropriate to start reducing asset purchase this year. The next FOMC meeting is scheduled in September, though it is not clear at this stage as to when the Fed will start tapering and at what pace. In any case, unlike the 2013 “taper tantrum” episode, it may not rattle financial markets. The reduction in asset purchase will mark the beginning of normalisation of what has been an unprecedented level of policy intervention.
The Fed balance sheet has doubled to over $8 trillion since the beginning of the pandemic. The US central bank is now buying assets worth $120 billion per month. The US economy, as a result, recovered swiftly despite witnessing the deepest contraction on record in 2020. But the sharp recovery has resulted in higher inflation. The headline inflation rate in July, for example, was at 5.4 per cent — the same level as the previous month. Mr Powell, however, reiterated that higher inflation was temporary. He explained that durable goods, for instance, were contributing about 1 percentage point to both headline and core inflation. But over the past 25 years, durable prices have been declining with an average inflation rate of negative 1.9 per cent. Although the surge in infection has complicated the economic outlook, a sustained expansion can increase inflationary pressures. To be fair, decision-making will not be easy for the central bank. A premature tightening can affect output in the medium term. However, a delayed intervention can increase the eventual cost of containing inflation. Monetary policy decisions are also more difficult because they work with a considerable lag.
However, as things stand today, the Fed’s policy normalisation is likely to be gradual. The surge in infection has slowed growth in consumption expenditure. Further, the Fed has moved to an average inflation-targeting framework, and is more likely to tolerate moderately higher inflation. Besides, it will not want to disturb financial markets. The announcement of tapering in 2013 resulted in significant volatility, which led to a near currency crisis in India. A slower normalisation will give emerging markets more time to adjust. Some emerging market economies have started normalisation despite a slower economic recovery.
To be sure, India is in a much better position than in 2013. Unlike then, the current account is in far better shape and India reported a surplus last fiscal year. It has also accumulated large foreign exchange reserves, which will help the Reserve Bank of India (RBI) manage volatility in the currency market effectively. But it still has two big pressure points — sustained higher inflation and a large general government Budget deficit with high public debt. As the world starts returning to normal, Indian policymakers will need to address these pressure points to preserve financial stability. The RBI is also of the view that higher inflation is transient. However, unlike advanced economies where inflation expectations are well-anchored, the margin for error in India is low. The government must also work on a medium-term fiscal plan. Continuing with crisis policy interventions for too long can create conditions for the next one.