Fresh research from the International Monetary Fund casts a novel light upon global inflation. Investigating its remarkable stability notwithstanding the significant rise of unemployment levels in Western countries, the just-released World Economic Outlook presents findings of singular import: Global inflation has become less responsive to changes in cyclical conditions while longer-term inflation expectations have become more firmly anchored. The implication is that inflationary consequences of large-scale monetary accommodation, or quantitative easing (QE), may not be significant if expectations remain firmly moored.
The research findings come amid growing apprehensions, including among some members of the US Federal Reserve, that although the monetary stimulus in the pipeline may reduce unemployment, this would be at the cost of overheating and a strong increase in inflation as occurred in the 1970s. In a chapter titled The Dog that Didn’t Bark: Has Inflation Been Muzzled or Was it just Sleeping?, the IMF uncovers a more muted response of inflation vis-à-vis changes in economic slack from the mid-1990s. This leads it to suggest that the stimulative effects of QE policies, likely to gather momentum with a strengthening recovery, may not exacerbate inflation in the manner understood so far.
What do these findings mean for India, for long trying to bottle the genie? World inflation seeps into its economy primarily through prices of oil and commodities, its key imports. The steady decline in wholesale-price inflation in the past few months, for example, is largely explained by stable oil and commodity prices. This is especially true for core inflation, which essentially reflects imported input prices, and moderated to 3.5% by March; of late, weaker domestic demand helped too. Past patterns show that prices of these items typically rebound as the output gap lessens. But changed inflation dynamics could upset this trend and any sharp reversal in world commodity prices could be a low probability event in the short to medium term as world output growth inches up to 3.3% in 2013 from 3.2% last year and then to 4% in 2014, according to IMF forecasts.
If global inflation is unlikely to resurge from the interplay of excess global liquidity with recovering demand, what does this imply for inflation projections in India in forthcoming times? More important, will inflation begin to trend southward from its current level? One is tempted to believe that if IMF’s findings hold in the short to medium term, the import component of domestic inflation would decelerate much faster than currently projected; the trend could consolidate further in the medium term with gradual easing of domestic supply constraints and any structural improvements in the current account balance.
Naysayers would believe it’s too early—most analysts expect inflation to stay at around 7% with a moderate recovery in GDP growth to 6-6.5% in 2013-14. It would, however, be interesting to see if RBI is persuaded to reexamine its inflation projection and try aggressively anchoring inflationary expectations towards its medium-term target, given the constellation of global and domestic demand-supply factors. While most would expect RBI to err on the side of caution, given its record in recent years for missing its projections on several counts, any rethink on the part of the central bank would surprise the markets and create space for more monetary policy action.
If global inflation unfolds differently than before in response to changes in the economic cycle, there is a strong case for RBI to take another look at the inflation dynamics and its inferences for monetary policy. IMF’s findings provide it with food for thought in this regard.
Renu Kohli is a New Delhi-based macroeconomist; she is currently Lead Economist, DEA-ICRIER G20 Research Programme, and a former staff member of the International Monetary Fund and Reserve Bank of India.