A fiscal retreat could be a useful way to fight inflation
4 min read 27 Dec 2022, 10:53 PM ISTPrice pressures could be fought without the unwelcome consequences of raising policy rates of interest
PremiumThe world economy is grappling with unprecedented inflation. If one were to look at the prevailing macroeconomic indicators of some advanced economies without knowing which country or part of the world they represent, it would not be an exaggeration to say no one would identify them with the developed West even in their wildest dream. For instance, the UK is witnessing one of its worst inflation spells in 45 years. The UK’s consumer price index including owner occupiers’ housing costs (CPIH) rose on a monthly basis by 1.6% in October 2022, compared with a rise of 0.9% in October 2021.
High inflation, low growth, high interest rates and high yields on treasury bills are typically characteristic of emerging nations faced with economic upheaval. But today, it is safe to assume that high inflation is driving the other macroeconomic indicators in advanced economies. What is causing this unprecedented inflation? It is mostly driven by two major factors. The first relates to the supply constraints caused by the covid crisis and the Russia-Ukraine war. The second relates to the demand spike caused by the unprecedented fiscal stimulus provided by various governments.
Governments around the world, especially in developed countries, are fighting back with monetary tools, essentially by increasing benchmark rates of interest. The US Federal Reserve, which is also the de-facto central bank of the world on account of its unique power of being able to print US dollars at will, has been at the forefront of raising policy rates. This has surely dampened inflation, albeit with a success rate that differs across geographies and not been without its consequences. Capital flight from developing countries and an appreciation of the US dollar even as the currencies of many countries crashed are some direct consequences of the Fed’s rate hikes.
Raising interest rates is not advisable even for developed countries, as it leads to higher input costs for industries and compromises the competitiveness of their products in the global market. With labour costs already high in developed countries, any price increase in other factors of production would lead to a renewed shift of factories to emerging markets where costs are lower. There is already a political backlash in advanced economies over this shifting out of their manufacturing base, which has caused a complete collapse of semi-skilled job availability there. It has also led to demands from some political spheres for inward-looking economic policies driven by mercantilism. In this backdrop, we must ask whether federal banks hiking interest rates is the only option for fighting inflation.
Though the fiscal stimulus provided by governments was the need of the hour during the pandemic, it could have been better targeted in many countries and withdrawn earlier. This stimulus added to aggregate demand in supply-constrained economies and fuelled inflation. Addressing an inflationary environment through a fiscal retreat could help put economies on a sound footing in the long run. Alongside, capital investment must be deployed to drive growth, while curtailing the fiscal deficit by cutting consumption expenditure. This will provide central banks with the leeway needed for them not to raise rates aggressively.
Though using fiscal tools to combat inflation is politically risky, it can provide a more robust and efficient way of doing it. It would also address externalities associated with interest rate hikes in advanced economies, such as a flight of capital from emerging economies and the resultant battering of their currencies. Many emerging economies are on the brink of bankruptcy partly due to the US dollar’s sudden strength.
India has so far managed the pandemic-induced economic crisis well. It has provided fiscal stimulus, but, unlike in developed countries, not gone overboard with it. In recent times, there has been an unscheduled meeting of the Monetary Policy Committee (MPC) to decide on benchmark policy rates in which the panel has decided to raise rates in India. It seems that this decision to raise domestic rates was primary driven by the actions of central banks in developed countries, and aimed at protecting the Indian rupee more than cooling domestic inflation.
Going too far with interest rate hikes to protect the domestic currency has not been an effective policy, historically. Let the rupee find its own equilibrium. The central bank should only ensure that there isn’t too much volatility in our currency market. In fact, a weaker currency may provide a fillip to the ‘Make in India’ initiative. A lower cost of capital, coupled with a stable polity as well as attractive macroeconomic indicators, can lure companies to base their factories in India. Also, as the Indian government looks to internationalize the rupee, central bank intervention in a currency market, directly or indirectly, is not taken favourably by global market participants; and so frequent tinkering, by means of interest rate hikes or otherwise, will hamper those efforts .
India should continue to reform its ‘factor markets’ , mainly for labour and land, and the government should unlock the unproductive capital stuck in inefficient public sector enterprises through monetization or strategic disinvestment.
The country has a golden opportunity to show its commitment to economic reforms and emerge as an economic powerhouse, given the broad uncertainties that hang over a large part of the globe.
Rahul Prakash & Neeti Shikha are, respectively, a financial economist and PhD candidate at the University of Texas; and a lecturer at the University of Bradford, UK.
