In retrospect, Friday’s rate hikes seemed inevitable. It was about time that the central bank responded to the growing accusation that it had partially taken its eyes off the inflation ball. It had delayed the decision, choosing not to react hurriedly to last month’s inflation release. There were other reasons for holding back — a local liquidity crunch and some unsettling news from international markets. What seems to have finally tipped the balance was the fuel price hike last week that adds roughly a percentage point immediately to inflation and quite a bit more over the longer term. Besides, the June inflation print due in mid-July is likely to appear somewhat alarming. HDFC Bank has forecast a level of over 11.5 per cent. A pre-emptive gesture was perhaps needed.
Does an inter-meeting rate hike (and the prospect of another hike in the July 27 policy) mean that the Reserve Bank of India (RBI) is accelerating its exit from the easy-money regime? I hope not. If indeed the lesson from the 2007-08 financial crisis is that central banks need to balance the objective of financial stability with inflation management, there is perhaps reason to be cautious. While the domestic economic news is heartening, one can’t say the same about the global economy or markets. There could be extreme volatility in external capital flows in the future, if not a massive pullout. An over-zealous central bank would end up compounding the problem.
A quick review of what’s happening in the wider world is perhaps in order here. While the jitters about the precariousness of the global economic recovery might have started in May with the crisis in Greece and other economies in the region, it is no longer a problem that is confined to Europe. The US housing market (an accepted bellwether for the broader economy) plummeted in May as new home sales fell by about 33 per cent over April. Despite the raft of stimulus measures, close to 10 per cent of the US’ workforce remains unemployed. The most alarming bit is the fact that Asia’s manufacturing sector, which seemed to have decoupled from the global business cycle earlier, seems to show growing signs of weakness. China’s manufacturing Purchasing Managers Index (PMI) for June printed at 52.1, down from 53.9 in May and 55.7 in April (for the uninitiated, a reading of anything below 50 suggests a contraction in the economy). South Korea and Taiwan have seen considerable weakness in their manufacturing indices as well.
There is a smug assumption that policy pundits like to make. If indeed the current trends presage another crisis, it would be somehow easier to handle than the last one. The experience of handling the last crisis (post-subprime and post-Lehman) should stand us in good stead. I am not that sanguine. For one, as the saying goes, “If you’ve seen one economic crisis, you’ve seen one economic crisis.” It is now a well-established fact that the cause and the dynamics of each crisis are significantly different from others. Thus it is likely that the contours of the impending crisis will turn out to be somewhat different from the previous one.
Some of the differences are obvious. The last crisis remained, to an extent, a problem of the banking and financial sector. One could argue that this made it easier to handle. Indeed, the first set of measures (the TALF and TARP in the US, and the European Central Bank’s liquidity measures) was focused entirely on ensuring that liquidity in the banking system did not dry up. The current problem seems far more diffused — a smorgasbord of sovereign debt problems, weak employment and retail spending, and an inventory adjustment cycle that has run its course. It could thus be far more difficult to handle.
The other thing that bothers me is the fact that over the last three years, policy-makers have tried every trick in the book to fight the recession and yet none of these measures has been a clear success. Expansionary fiscal policy, for one, seemed to have worked for a while but it also seemed to have bred a new set of problems. Keynes’ remedy might have prevented a depression in the US but it left southern Europe on the brink of fiscal collapse. Soon, the US will have to think of ways to address its fiscal crisis. If indeed governments have exhausted the manual of quick-fixes, it remains to be seen which rabbit they pull out of the hat this time.
There is a camp led by the likes of Paul Krugman that believe that the only way out is to continue with expansionary fiscal policy (possibly introduce another stimulus) and think about the tab later. I see some merit in this. Let’s get one thing right. The US is not Greece. Heavyweight western economies — the US, the UK and certainly Germany — can pull off another round of fiscal stimulus without necessarily facing a debt crisis, the somewhat alarming fiscal ratios (the US is likely to have a budget deficit-GDP ratio of over 13 per cent in 2010 and a debt-GDP ratio of 100 per cent in 2011) notwithstanding. Continued fiscal stimulus is not just important for their domestic economies, there could be significant externalities as well. Germany is the pivot for Europe — if it loosens its purse strings, the entire region stands to gain.
However, there seems to be very little political support for this view. The impasse over the jobs Bill in the US Senate (that would extend another $34 billion in unemployment benefits) seems to suggest that more fiscal stimulus in the US is unlikely. Germany has decided to slash expenditures by about ¤60 billion over the next four years instead of pump-priming.
Also Read
For Indian policy-makers, the implications should be clear. A number of policy decisions seem to be predicated on the assumption that we need to somehow get back to a path of “normalisation”. This includes both monetary and fiscal policy (the decision to align fuel prices with international trends for instance). For an economy that has become closely aligned to the globe, the question to ask in taking decisions is whether indeed the world economy is slowly returning to a new “normal”. My claim is that it isn’t.
The author is chief economist, HDFC Bank. The views expressed are personal