Sunday, June 22, 2008

Central Banks should turn to slowing down growth!

The relentless march of inflation continues, and there appears no end in sight! Small and big, rich and poor, developing and developed countries have all been consumed by this rising tide of inflation. Unfortunately, this rise in inflation was to have been expected given the unsustainably high pace of growth in the world economy in the past two decades. The global economy is experiencing a clear supply crunch in commodities, foodgrains and energy, as the growth in demand, especially from the China and India led emerging economies shows no signs of abating. In this context, the only medium term solution is to slowdown growth and thereby demand. The time may have now come for Central Banks across the world to co-ordinate and raise domestic interest rates uniformly, not to combat inflation but to slow down growth.

Inflation figures for the week ended June 7, showed a 13 year high of 11.05% in India. This was expected after the Government had finally bowed to the strains being placed on the fiscal balance by rising oil prices and raised petroleum and diesel prices by an average 10% on June 4. (Petrol, diesel and LPG contributed 94% of the rise.)

The Chinese government followed suit on Friday, raising retail fuel prices by up to 18 per cent and jet fuel by 25 per cent. This rise is certain to drive inflation closer to or even reach double digit. Inflation in China had already breached a 12 year high in February and was 7.7% in April. Even the developed economies of Asia are not spared, as Singapore's inflation touched a 26 year high of 7.5% in April.

Oil prices are increasingly driving the inflation figures and emerging economies of Asia with their high dependence on imported oil are feeling the brunt. Inflation figures are 25% in Vietnam, 26.5% in Sri Lanka, 19.3% in Pakistan, 10.6% in Bangladesh and 10.38% in Indonesia. Global consumer price inflation is expected to jump from 2.4% in February 2007 to 4.3% in June 2008.

The Goldman Sachs index of commodity prices has doubled since early 2007. Nominal prices of oil have increased by 150 per cent over the same period. The upward movement in commodity prices has persisted for 6½ years. It looks as though too much extra demand is pressing on too little ability to increase global supply. The world economy is simply unable to meet this level of sustained demand.

The RBI had raised its key repo rate by 25 basis points to a five year high of 8% in early June. Analysts expect another 25 points hike in repo rate soon, even before its July 29 quarterly review. The market is settled to the expectation that the Central Bank will raise the rates in these small increments. The same is true of other emerging economies and their Central Banks.

But unfortunately, this policy of incremental hike may do little to rein in inflationary expectations. These expectations are too entrenched and may not respond to such cosmetic tinkering. Further, the cost-push nature of inflation means that inflation is driven by global demand supply conditions that are beyond the control of individual nation states. Such monetary policies will only bleed growth, without delivering on the inflation front. A condition of stagnant growth with persistant inflation could be the reality in many countries by mid 2009.

Under the circumstances, given the supply constraints faced by the global economy and the nature of the inflation, it may be appropriate for Central Banks, especially in China and other emerging economies, to turn away from inflation fighting to the more immediate need of slowing down growth.

On the positive side, the US economy is clearly slowing and may even be in a recession. It is now important that the other economies, especially China, follow suit. And we are only talking about slowing down from the breakneck pace of 9-10% to a more reasonable and sustainable 5-7%, atleast for the short term.

It has been observed from central bank policies elsewhere that rising rates in small increments rarely ever yields the desired results. The expectations of small rate hikes gets embedded and gets discounted for by the market, and has little effect beyond its immediate aftermath. While it may be suited to combatting mild inflation, it is surely not appropriate for addressing the present challenge.

In contrast, larger and limited number of rate hikes, over shorter time intervals, may both shake up inflationary expectations and put immediate downward pressure on growth. Two or three rate hikes by 100 basis points may do the trick. But the hikes may have to be done by co-ordination between global Central Banks, so as to have the desired effects. Else, the presciption may turn out exacerbating the crisis!

Update 1
Nouriel Roubini feels that the most effective way to contain inflation is to allow currencies in the emerging economies to appreciate significantly. If the nominal exchange rate is not permitted to appreciate, real appreciation can occur only through an increase in domestic inflation.

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