The latest news on inflation in the world’s largest economy, the United States, gladdened central bankers all over the world. Of course, the most relieved central bank was the US Federal Reserve (the Fed). The monthly inflation rate in the United States for October 2022 was less than the predicted rate of 8.0 per cent, according to data released on November 10. Inflation was 7.7 per cent in October, falling from 8.2 per cent in September, confirming the much-awaited declining trend since the Fed began its tightening monetary policy in May 2022, which was a delayed response to a period of more than 12 months of inflation.
Similarly, India’s inflation data reported on November 14 showed retail inflation easing to 6.8 per cent in October from 7.4 per cent in September. However, it is still higher than the allowable upper limit of 6 per cent, accommodating a margin of 2 per cent above the targeted rate of 4 per cent. The response from the Reserve Bank of India (RBI) to the rise in inflation from February 2021 was also delayed until April 2022. All along, inflation was above the tolerance limit of 6 per cent. The RBI raised the policy rate of interest in May 2022 to 4.4 per cent from 4 per cent.
End of the cheap money era
The US inflation build-up began in March 2021, breaching the Fed target rate of 2 per cent. For nearly one year, the Fed ignored inflationary signs, saying they were due to transitory factors. Monetary tightening measures, including shrinking the balance sheet by winding up the quantitative easing and ending the low interest era of cheap money policy, began only in May 2022, when the Fed raised the policy interest rate from the historically lowest rate of 0.25 per cent in April to 1.0 per cent in June. As inflation was relentless, the Fed began to increase the rate thereafter, steadily reaching 4 per cent in early November.
The current global situation of high inflation is a result of the easy money policy pursued by central banks for many years with low interest rates to meet the needs of the Great Recession (2008–2009) and for recovery. Delays during the taper-tantrum years (2013–15) in getting back to normalisation of monetary policy prolonged the easy money era. The Covid-19 pandemic in 2019 with lockdowns extended the same policy stance three more years. The Russia-Ukraine conflict since February 2022 and high oil prices have compounded demand-supply imbalances. The Nobel Laureate Milton Friedman’s dictum, “Inflation is a monetary phenomenon,” still holds good.
While raising the interest rate to 4.0 per cent, Fed chair Jerome Powell said, “My colleagues and I are strongly committed to bringing inflation back down to our 2 per cent goal.”
Poor countries pay higher price
With the October inflation data at 7.7 per cent, the US price level is on a downward path. But at what cost? Contractionary policies by advanced economies have wrecked the economies of developing countries. Uncertainties arose from fears of recession due to a fall in all components of aggregate demand. Due to high borrowing costs, private sector investment has decreased; consumption of durable and semi-durable goods, as well as frequently marketed consumer goods, has also decreased, resulting in job and income losses, raising fears of a recession. Steady increases in the Fed interest rate led to a reversal of capital outflows back to the US as the interest rate spread between the US and the rest of the world narrowed, restoring the safe-haven attraction.
Consequently, the US dollar has appreciated by more than 13 per cent against world currencies. That depreciated poor countries’ currencies much more, rendering their imports more expensive. A rise in real exchange with adjustments for relative inflation also discouraged export competitiveness in poor countries.
What is in store for the world? “The US and advanced economies should be cognizant of their policies having spillover effects on the rest of the world,” Janet Ellen, the US Treasury Secretary and a former Fed chair, told reporters in Bali on the eve of the G-20 Meeting of Presidents and Prime Ministers of the top 20 advanced economies and EMEs.
A realisation, too late
A widely discussed topic for the past six months and a matter of grave concern to rich and poor nations alike is the recession. Referring to a forecast of 60 per cent probability by economists and the past record of such forecasts, Ruchir Sharma in an article in the Financial Times on November 7 raised his doubts about the forecasts of recession. That was before the November 10 US inflation data. He quoted John Maynard Keynes: “The inevitable never happens. It is the unexpected always.”
Economists’ forecasts are based on statistical models using past time series of relevant variables to obtain parametric coefficients. These coefficients themselves are not constant, and forecasts made on the basis of past values become unreliable. In a letter to the editor of the Financial Times on November 9, Giovanni Farese, an economic history professor, told us that Keynes was inspired by the Greek tragedian Euripides’ play Bacchae. The final chorus ending has these words:
“God has many shapes/ God brings many things to their accomplishment/ And what was most expected has not been accomplished / But God has found his way for what no man expected.”
Farese concludes that economics, which is not a natural science, can, however, “teach the sort of practical wisdom that the classics cherished and that decision-making in the real world so often requires.” The monetary authorities used their practical wisdom during recent months, compensating for their delayed action for more than a year under the mistaken belief that inflation signs were transitory.
So, not the mathematically inevitable, but the expected result from the use of practical wisdom shows there is no likelihood of recession.
(The writer, a former economist at Asian Development Bank, is an Honorary Adjunct Professor, Amrita School of Business, Bengaluru)