RBI should continue the unwinding process
Higher inflation has complicated policy choices for most central banks, including in advanced economies. Central banks reduced interest rates and pumped liquidity into the system last year to deal with the disruption being caused by the Covid-19 pandemic. But the pace of economic recovery and pick-up in prices have surprised policymakers. Higher inflation, particularly in advanced economies, is being driven in part by pent-up demand, supply disruption, and higher commodity prices. Inflation rate in several advanced economies is running above the target of 2 per cent. The rate in the US in September was over 5 per cent, while it went up by 3.4 per cent in the eurozone. Most central banks maintain that higher inflation is transitory and largely a consequence of supply-side disruptions.
The dilemma for central banks is that if they decide to ignore price pressures for too long, it could affect inflation expectations and make policy management more difficult. It is not very clear how quickly supply-side disruptions would completely abate. Increased dependence on global supply chains makes such forecasts more difficult because a surge in infection in one part of the world could affect the availability of goods in another. But if central banks tighten too quickly, it could affect the ongoing recovery and increase volatility in financial markets. Thus, since there are a number of moving parts in the system, policymakers will have to move carefully. The US Federal Reserve last week decided to reduce the quantum of asset purchase from the market. A number of market participants now believe that interest rates will rise sooner than what was expected earlier.
Policy action at the Fed and other central banks would depend on how prices move over the coming months. The Bank of Canada, for instance, has ended its bond buying programme, while the European Central Bank intends to continue with the current policy. Although it’s not clear when all supply lines will start functioning normally, global commodity prices seem to be stabilising. The latest reading on the commodity price index, compiled by The Economist, showed a decline of 2.3 per cent compared to the previous month. However, compared to last year, the index is still up by about 17 per cent. Thus, while global inflation might remain elevated on a year-on-year basis, financial markets would start factoring in the momentum. To be fair, there are a number of factors affecting inflation outcomes at this point, and an increase in Covid-19 infection could reverse recent supply-side gains. The International Monetary Fund expects inflation to return to the pre-pandemic levels by the middle of next year for a group of advanced and emerging economies.
Being a net importer, higher global inflation has implications for India. The Central and several state governments recently reduced taxes on petrol and diesel to lower pump prices. This would help contain inflation, though the rate has come down in recent months. Stabilisation in global commodity prices would improve the inflation outlook for India as well. In terms of policy, the Reserve Bank of India (RBI) has gradually started unwinding excessive accommodation and would do well to continue the process. The inflation rate in India has been on the higher side since last year. Therefore, the challenge for the RBI is to bring it close to the 4 per cent target on a durable basis. Unwinding excessive policy accommodation would also help address the build-up in asset prices.