Keep track of trade turbulence amid a scenario of benign inflation

The Reserve Bank of India (RBI) had held monetary policy too tight through much of the past three quarters, at a time when low core inflation was signalling weak demand conditions in the Indian economy, while high food prices were stoking fears that these could spill over into other parts of the economy. It was a policy paradox. However, the possibility that high food inflation would spread to the rest of the economy seemed unlikely, since neither were wages being pushed up nor were there indications that high prices were spilling over into other sectors.

Also Read: Mint Quick Edit | Inflation: In RBI’s control at last?

There are two possible reasons why high food inflation did not light a broader inflationary blaze as it did in the early years of the previous decade, or why it did not spread to core inflation. First, inflation expectations remained stable, so neither did workers begin to demand higher wages nor did companies increase the prices of their products. Second, both sets of economic agents would have liked to bid up prices, but were unable to do so because of widespread slack in the economy.

This is at odds with the fact that the economy is growing at around the rate that most economists estimate as its potential. The stability of inflation expectations thus seems the more reasonable explanation, which is a win for the credibility of Indian monetary policy.

What next? Monetary policy should be crafted by looking at what lies ahead, rather than what has been left behind; or, as economists like to say, it operates with lags. Much of Asia now seems to be in a phase of disinflation. India is no exception. Inflation risks seem low right now, creating conditions for a further loosening of monetary policy through the rest of the year.

Also Read: Nitin Pai: Trump’s tariffs serve political ends even if they lack economic logic

But that is as far as a normal world goes. We do not live in normal times. US President Donald Trump is out to upend the international trading system that has served the global economy very well since 1945. Nobody can say for sure what will replace it, but the risk of erratic tariff hikes by the US—and perhaps retaliatory action from its trade partners—injects a massive dose of uncertainty all across the world. This will have consequences for monetary policy as well.

The standard method of thinking through the impact of higher tariffs on monetary policy was provided by Robert Mundell and Marcus Fleming in the 1960s. Much depends on the exchange rate policy of a central bank. Under a flexible exchange rate, a tariff hike will initially reduce imports, improve the trade balance, reduce the demand for foreign currencies to buy those imports, and thus end up with currency appreciation. Later, this currency appreciation will at least partially neutralize the effect of tariffs by making imports cheaper.

However, in the case of a fixed exchange rate, the central bank will move to prevent currency appreciation. It will add to its reserves while releasing more liquidity in the domestic economy. The higher liquidity will be inflationary, unless this intervention in the foreign exchange market is sterilized through the sale of local currency bonds.

The underlying point is that tariffs will interact with domestic monetary policy as well as the exchange rate regime to impact price levels. The response of Indian monetary policy will also need to be examined through these filters.

Also Read: Looming US tariffs could be bad news for India’s Big Five

Another nuance worth considering is whether tariffs are imposed on consumer goods or intermediate goods. It is likely that there will be a one-time impact on prices in case tariffs are imposed on consumer goods. That is not so in the case of tariffs on intermediate goods—think semiconductors—which are used in a range of other industries. Once again, monetary policy will have to be sensitive to such important distinctions.

Given that India has higher average tariffs than the US, the principle of reciprocal tariffs means that India could actually reduce its tariffs in response to US pressure, as some newspaper reports on the trade negotiations between the two countries indicate. The other factor is that China may redirect its surplus production to the rest of Asia in response to being shut out of the US market. That could prove to be a disinflationary shock for many economies in the region.

The upshot: Even as the inflation risk recedes in the domestic economy, Indian policymakers will have to calibrate their response to any trade turbulence in the coming months. A host of other factors will matter, including the direction of Indian tariff rates, which sectors tariff changes are likely to focus on, the exchange rate regime, a deeper disinflationary shock emanating from China and broader geopolitical negotiations. These lurk in the background of an overall benign inflation situation.

The author is executive director at Artha India Research Advisors.