Financial markets have been reeling in recent weeks, with many central banks taking belated action to put out the fires of inflation in their respective countries.

The cost of living is rising rapidly across the world. However, the scale of the problem is not the same in all countries. The dispersion of price pressures should be considered not only in terms of headline numbers, but also in terms of the gap between the latest inflation figures and the official or implicit inflation targets in these economies. Inflation has moved away from inflation targets in major western economies such as the US, UK, Germany, Spain, Canada and Belgium. Many Asian countries currently have lower inflation than the first group, for example Japan, Indonesia, Malaysia, the Philippines, South Korea and Taiwan.

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It’s time to tighten up now

The latest monthly inflation figures in India and Thailand are high by regional standards, but still lower than many rich countries. The third group is made up of countries that are subject to macroeconomic fears anyway: Turkey, Argentina, Brazil and Pakistan. Their inflation is well above global averages. And then there’s China, where inflation is still not an issue, perhaps because strict lockdowns have artificially suppressed domestic demand there.

These varied inflation patterns mean that global monetary policy coordination is likely to be tested as central banks normalize policy at different speeds. Normalization includes both higher interest rates and the removal of excess liquidity from financial systems. The severity of monetary tightening will depend on the balance of two factors. First, countries where inflation is now well above the inflation target will need to act more quickly. Second, countries where central banks have strong credibility may get away with more muted reactions than those where trust in central banks is low.

The Reserve Bank of India (RBI) started the year with a relatively optimistic outlook for inflation. It has since evolved rapidly, raising its key policy rate by 90 basis points since early May. Further rate hikes are now expected for the rest of the year. The repo rate is still 170 basis points lower than the average inflation expected for the current fiscal year.

Another way to guess the end point of India’s ongoing monetary tightening is to use three sets of variables.

First, the neutral interest rate that can keep economic growth close to potential while keeping inflation close to target. Second, how the central bank estimates the gap between actual growth and potential growth on the one hand, and expected inflation and its inflation target on the other. Third, the weights it assigns to the output gap and the inflation gap when deciding interest rate policy.

However, interest rate policy is not everything. Like its peers in other countries, RBI will also have to manage its balance sheet. A recent note from the US Fed shows that a permanent reduction in the Fed’s holdings of 10-year US government securities equal to 1% of nominal GDP increases the term premium of a government security of the same maturity by 10 basis points. This means that monetary tightening must be considered both in terms of the price of money and the size of the central bank’s balance sheet.

RBI’s balance sheet can then be seen in this context. The chart below shows the trend in the size of RBI’s balance sheet as a percentage of nominal gross domestic product (GDP) over the past 25 years. The 1997-98 financial year is a good starting point, as it was the year the RBI was freed from the obligation to automatically finance the Centre’s budget deficit, a change which was later reinforced in the Act of 2003 on budgetary responsibility and budgetary management.

The data shows that, apart from fiscal year 1997-98, the size of RBI’s balance sheet has varied between 19.43% and 29.09% of nominal GDP. The number moved closer to the upper end of the range in 2020-21 for three reasons: RBI bought dollars flowing into India at the time, it increased its holdings of government securities through operations open market in order to support the government. borrowing program at low interest rates and nominal GDP itself has fallen due to the pandemic.

RBI’s balance sheet decreased by 3.3 trillion, or 1.4% of nominal GDP, since October 2021. Much of this reduction is due to a recent loss of foreign exchange reserves, although the depreciation of the rupee has helped to mitigate the impact on the balance sheet of the central bank in terms of Indian currency. A smaller balance sheet, both in terms of absolute numbers and as a proportion of nominal GDP, will impact the liquidity of the domestic financial system, although it will also have other factors such as currency in circulation and cash balances. government to the central bank.

In its recent Money and Finance report, RBI estimates that excess liquidity of more than 1.52% of net term and demand deposits is inflationary; and that an exogenous increase of 1 percentage point in liquidity can raise inflation by 60 basis points in one year. The upshot: The trajectory of the repo rate as well as how RBI manages its balance sheet will need to be watched as the fight against inflation intensifies.

Niranjan Rajadhyaksha is CEO and Principal Researcher at Artha India Research Advisors, and a member of the Academic Advisory Board of the Meghnad Desai Academy of Economics.

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