Explain Speaking: The Reserve Bank of India (RBI) and the US Federal Reserve – the paradoxical tale of two central banks
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Last week, within hours of each other, the central banks of India and the United States raise interest rates He pointed to tighter monetary policy in an attempt to contain rising inflation. It is certain that thanks to the supply disruptions during the Covid pandemic and, more recently, due to the sharp rise in the prices of various commodities (especially food and crude oil) following the Russian invasion of Ukraine, inflation has already become a global concern.
Many of you have probably heard an informal comment that roughly translates to the following: The RBI has acted proactively. There was little he could do, after all, inflation is a global problem nowadays. Just look at the United States. Even the US Federal Reserve (or Federal Reserve) had to raise interest rates.
Does this mean that India and the US – just take two examples – are in the same boat when it comes to inflation?
The short answer is: No, India and the US are facing the same crisis – high inflation – but they are not in the same boat. That is why the same steps (reading higher interest rates and shrinking money supply) taken by the two central banks to control inflation, are expected to harm the Indian economy much more than they harm the US economy.
In particular, with interest rates rising, India should prepare for higher levels of unemployment in the coming months.
Now for the long answer.
To understand the discrepancy between the two economies, one must take into account four factors:
- What is the primary strength of the economy before it faces the two back-to-back shocks (i.e. the turmoil caused by the Covid virus and the geopolitical turmoil in Ukraine)?
- How strong is the recovery in the two countries?
- What are the causes of inflation? What do the relevant central banks hope to achieve?
- What is the level of unemployment as the respective central banks have begun to tighten monetary policy? How will you be affected?
Basic state of the economy before Covid
Just because both India and the US are facing high inflation right now doesn’t mean the two primary economies were equally unhealthy before Covid.
As detailed in explained last week, Which used the latest Reserve Bank of India (RBI) report on currency and finance, India’s economic growth has been steadily losing growth momentum since October 2016.
In a country like India which often experiences growing unemployment, the rapid slowdown in economic growth has come with its most obvious repercussions – massive unemployment, Wage growth falters, and disillusionment among workers (especially the educated youth) grows.
Compare this with the United States, which has had the longest expansion (more than 10 years) in its economic history.
An important thing for readers to note here is that, in terms of total GDP, the US economy is nearly ten times the size of the Indian economy. The disparity is even greater when it comes to per capita income – per capita income in the United States is more than 30 times.
This is why it is misleading to think that 4% annual GDP growth means the same thing in the two countries.
How strong is the recovery after covid?
It is a fact that both economies have briefly entered a recession, thanks to the shutdowns and disruptions caused by the Covid virus. However, there are fundamental differences.
While India has barely managed to get back to the same level of GDP it had before the Covid pandemic, the US is one of those rare cases, where the recovery has been so steep that the economy barely loses a step.
In Chart 1 (sourced by Nomura Research), the data is based on the International Monetary Fund’s projections of the level of real GDP for countries in 2022 made at two time points, April 2022 (latest) and October 2019 (pre-pandemic). The percentage change is displayed in the columns. The results show that for most countries, the IMF projections made in April 2022 are lower than those made in October 2019.
Note, the hugely contradictory recovery in the US and Indian economies.
What are the causes of inflation?
This leads us to the cause of inflation in the US and India, respectively, and for how long.
For example, in India, inflation was well above the Reserve Bank of India’s target (4%) long before the nationwide lockdowns caused by the Covid virus were announced at the end of March.
Compare that to inflation in the US, which held well within the US Federal Reserve’s 2% target until the first two months of 2021.
However, inflation in the United States has now reached its highest level in four decades while the situation in India is still not alarming.
But there is another aspect when it comes to what is causing the inflation rates to rise in the two countries.
In the United States, rising inflation is due in large part to a rapid economic recovery. This is called “demand-pull” inflation. In the wake of the pandemic, the US government provided massive support to the economy in the form of stimulus money grants, which led to a huge rise in aggregate demand which not only boosted GDP but also raised the price level.
There was another reason for inflation – the so-called “cost-paid” inflation. This was in the form of supply bottlenecks – such as labor shortages or the disintegration of supply chains – which drove up costs, such as higher wages for workers, which in turn drove up prices and higher inflation. The sudden rise in food and energy prices in the wake of the Ukraine crisis has fueled cost inflation.
By contrast, inflation in India has been high even though there is a demand deficit. Of course, much of the inflationary pressure can be explained by supply bottlenecks, but it is critical that aggregate demand in India is barely above the pre-pandemic level. To this extent, rising inflation in India even without a recovery in demand is a troubling reality.
Add to this India’s much larger vulnerability because the country relies on imports for 80% of its total fuel needs.
This is perhaps the most important factor.
In India, unemployment was the highest in nearly the last 45 to 50 years even before the pandemic. Sharp contraction and recovery from anemia didn’t help matters. This is partly related to the fact that India is also going through a phase where millions of people are entering working age every year.
Compare this with the situation in the United States. While inflation is at its highest level in four decades, the unemployment rate in the United States is at its lowest level in five decades. There are 11.5 million vacant jobs in the United States and only 6 million are unemployed. This means that there are two job openings for every unemployed person in the US as of last week.
“Employers are struggling to fill jobs, and wages are rising at the fastest pace in many years,” Fed Chairman J. Powell said. During the first three months of the year, employment rose by about 1.7 million jobs. In March, the post-pandemic unemployment rate hit a five-decade low of 3.6 percent. Improvements in labor market conditions were widely spread, including to workers at the lower end of the wage distribution, as well as to African Americans and Hispanics. He said the demand for work is very strong.
Indeed, according to President Powell, the central point of raising interest rates is to discourage employment in the US economy and thus reduce the mismatch between supply and demand in the labor market. This is because the massive mismatch results in such rapid wage increases that there is a fear that wage increases may get out of control and lead to higher inflation.
Wages are rising, their highest levels in some time. And it’s a good example of — or a good illustration, really — of how tight the labor market really is, the fact that wages have been operating at the highest level in several decades. “This is due to the imbalance between supply and demand and the labor market,” he said during a media interaction.
What do these factors tell us about the potential impact of containing inflation in India and the United States?
Tighter monetary policy (i.e. higher interest rates and a lower money supply) usually reduces aggregate demand. Central banks resort to this policy when they find that the economy is overheating – the widening gap between supply and demand – and causing inflation.
Containing inflation comes at the expense of lower economic growth and higher unemployment.
This is where the economists’ basic situation – India versus the US – makes all the difference.
India was struggling with weak economic growth and high unemployment before the crisis. Moreover, despite the efforts of the Reserve Bank of India (RBI) to boost growth, India’s recovery is uneven and inadequate even as unemployment continues to be a major concern.
In sharp contrast, the United States entered a Covid recession after enjoying the longest economic expansion in history. Moreover, its recovery may be the best in the world as unemployment touches a historical low and wages are posting sharp increases.
In other words, the high inflation in the US economy is in fact due to its overheating. Actions intended to delay its overall growth will stifle job growth, but then – and this is the crucial part – the US actually has two jobs for every unemployed person, and as such, it could take such a hit. In fact, reducing this demand for workers by firms is the central objective of Fed policy.
India, on the other hand, does not feel comfortable when it comes to unemployment.
Can the United States enter a recession? Could India suffer from stagflation?
These are valid concerns.
When asked, President Powell said this about the prospects for the US economy going into recession:
I think we have a good chance of restoring price stability without a recession, you know, without severe deflation and without materially higher unemployment. The reasons for this have been mentioned. So I see a strong economy now. I see a very strong job market, for example. Companies cannot find people to hire. They can’t find them. So usually in recessions you will have unemployment. Now you have excess demand. So there must be scope, in principle, to reduce this excess demand without putting people out of work.
As for India facing stagflation – which is described as a phenomenon when the economy suffers from stagnant economic growth (which leads to predictably high unemployment) and persistently high inflation – some argue that India is already facing it.
But even if such views are ignored, the fact remains that even before persistent high inflation hit India, it was suffering from high unemployment rates. That is why policies that dampen growth now will only exacerbate unemployment – at least in the short term.
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