By initiating the rate hikes, the RBI can cement the credibility of its monetary policy intent and action as it combats supply-driven inflation on the one hand and also contains the negative impact on growth, according to one article.
The document was drafted by three RBI analysts, including Deputy Governor Michael Debabrata Patra, who is a member of the Monetary Policy Committee (MPC) ratings setting committee and also heads the bank’s key monetary policy department. central.
The article was published in the July RBI Monthly Bulletin but does not officially represent the view of the monetary authority.
Emphasizing that the current pain of inflation is global and supply-driven and can best be tackled through fiscal measures and not monetary policy actions such as rate hikes, the article notes that Ongoing supply shocks are larger and more incessant, carrying the risk of “unanchoring inflation expectations”.
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They are also accompanied by a rebound in pandemic-related revenge spending, leading to a gradual narrowing of the ongoing output gap.
Therefore, coordinated monetary and fiscal policy responses are needed to deal with it, because “given the limited room for manoeuvre, frontloading of monetary policy measures can keep inflation expectations firmly anchored, thus preserving central bank credibility, realigning inflation on target and reducing the medium-term growth sacrifice,” says the article by Patra, Joice John and Deepak Kumar.
The article squarely blames the devastating global inflationary pressures on crude oil prices and the resulting ripple effect on other commodity rates following the Russian invasion of Ukraine.
Using crude prices as an example of supply shocks, RBI quarterly projection model simulations show that when the shock is transitory, inflation returns to equilibrium without any monetary policy action being taken. necessary.
On the other hand, repeated supply shocks trigger second-round effects via cost pressures, inflationary expectations, exchange rate volatility and demand channels, justifying preventive monetary policy action.
“Lack of credibility can even reduce monetary policy response and therefore by pre-fueling monetary policy actions, credibility is demonstrated by showing commitment to the inflation target.
“The required monetary policy response is weaker when there is a fiscal policy response to supply-side shocks, but the latter carries macroeconomic costs, including potentially lower growth in the medium term,” indicates the item.
If the central bank is seen as credible in its intentions, words and actions, timely monetary action can reduce the long-term impact on growth, he added.
The article also cites the World Bank as setting global median inflation at its highest level since 2008. For advanced economies it is at its highest level since 1982 and in the United States it is at its highest level for 41 years.
This surge in inflation has its origins in a series of supply shocks — pandemic shutdowns, supply chain disruptions, high commodity prices and war in Ukraine.
The energy component of global consumer price inflation is at its highest level since the early 1980s. For more than 40% of emerging markets and most low-income countries, the consumer price index consumption and food inflation are expected to remain in double digits until 2022.
Therefore, the global inflation crisis is only the face of one of the most serious food and fuel crises in recent history which now threatens the most vulnerable across the world, he added. .
In a world where high inflation is globalized, “it is the direction of change that counts, not the height” and at the center of this exercise is “the role of credibility of monetary policy and anchoring of expectations of ‘inflation”.
Rising crude prices increase other international commodity prices, fuel global inflation and weaken global demand and growth.
The direct impact of rising crude oil prices on inflation occurs due to the pass-through to domestic prices of petroleum products. Second-round effects occur through cost-push – oil prices raise the prices of intermediate goods and services which, in turn, drive up the prices of final goods and services.
There is also a transmission channel from demand to domestic inflation at work – higher fuel prices reduce consumption of other items and reduce business profit margins, leading to lower cash flow and lower investment.
If the price of crude increases by 10%, inflation can increase by about 30 basis points at its peak, with GDP growth 20 basis points lower. Therefore, a tightening of monetary policy is necessary to bring inflation back to its target, he added.
The monetary policy response widens the output gap, compresses demand and thus lowers inflation. On the other hand, if fuel taxes are reduced by 10%, inflation may fall by about 15 basis points and GDP may gain 20 basis points, according to the article.