How India and the US contained inflation without hitting growth?

10 Mar 2024 , 07:45 AM

WAS IT PLANNED, OR WAS IT CHANCE?

In a sense, the anti-inflation battle by the world’s leading central banks post 2021 is the stuff that legends are made of. Leading central banks globally hiked interest rates aggressively in a reminder of what Paul Volcker had done more than 40 years back to rein in runaway inflation in the US in the early 1980s. However, two case studies stand out among the global economies viz. the US and India. We are only considering large economies with annual GDP of more than $1 trillion in this case. What was so special about the US and India?

Both these economies managed to rein in inflation without impacting the growth engine. Let us take the US case first. The PCE inflation (the Fed benchmark) has been brought down to 2.4% as of the last data available for January 2024 and that is just about 40 bps away from the Fed target of 2%. This was achieved even as full year growth was above 3.1% for 2023 and 2024 also promises to be robust. What about India? India brought down its inflation level from nearly 9% in mid-2022 to 5.1% in January 2024. This feat was achieved even as India remains the fastest growing large economy in the world at 8.4% in Q3-FY24.

What makes the case of India and the US special is that both the economies have managed to sustain their economic growth even while using hawkish monetary policy to rein in inflation. This is at a time when the UK and Japan have officially slipped into a technical recession (2 consecutive quarters of negative growth). EU is just about struggling to maintain positive growth and China is beset with problems surrounding its banking sector and the extremely leveraged realty sector.

HOW DID THE US AND INDIA MANAGE THIS DUAL MANDATE?

Actually, if you look at the two economies of the US and India closely, there are two things that are common. Firstly, both the economies managed disinflation without impacting the GDP growth engine. In fact, the GDP growth has emerged stronger than it was prior to the pandemic. Secondly, both the economies also managed disinflation without a rise in unemployment. Both these are trade-offs that the economies would have faced. However, the possibility is that either the trade-offs were not there or they were not apparent.

Some of the answers to these questions were given by the Fed Chief Economies, Adriana Kugler, when she addressed the Stanford Institute for Economic Policy Research, at the Stanford University, California. According to Kugler, this debate becomes all the more relevant in the post-pandemic world, wherein the real shocks did not come from the demand side but they came from the supply side. The COVID pandemic disrupted the global supply chains due to the shutdowns; especially the inordinately prolonged shutdown in China, which has been at the heart of the global supply chain for a very long time. The sudden supply disruption, post pandemic, resulted in a sharp spike in inflation, which was exacerbated in early 2022 by the Russian war in Ukraine. For both the economies; India and the US, the mandate was unenviable. Inflation had to be controlled at any cost. However, the economic managers of both economies also knew that trying to contain inflation at the cost of growth or jobs would have been disastrous. In the final analysis, the balancing act of containing inflation without hitting growth and jobs was partially planned, but it was also largely an outcome of sheer chance.

INFLATION, JOBS, AND GDP GROWTH: HOW HAS BEEN THE EXPERIENCE?

At the peak of the pandemic, the US economy had also seen two consecutive quarters of negative growth leading many economists to talk about an impending recession and a hard landing of the economy. Fortunately, for the US and the rest of the world, nothing of that kind happened. In the US, inflation did come down from above 7% to about 2.4%. While inflation is still volatile, it now looks increasingly likely that it may stay in a range at the lower end and the volatility would be more of noise and less of a structural issue. That is evident from the pace at which the core inflation has fallen in both the economies. For instance, the core inflation has fallen to 2.8% in the US and to 3.8% in India.

Let us also talk about the jobs situation in both the countries. In the case of the US, the unemployment rate which had spiked during the pandemic has now come down to 3.7%, very closer to the level of 3.5%, which is defined as the level of full employment in the US. If you look at the Indian context, the level of unemployment has also come down from over 8% in the aftermath of the pandemic to a level of around 3.5%, as per the latest jobs survey. In short, the US and the Indian economy have not only managed to keep growth robust, but even have kept the jobs situation robust amidst inflation falling sharply in the aftermath of sustained rate hikes. But, how exactly did this happen.

Achieving dual mandate: the role of chance in the US and India

One way to dismiss this would be that this dual mandate was purely a shot of dame luck. However, while there was a role of chance here, there were also several conscious measures taken by both the economies. But first, let us look at the role played by chance (or good luck) in achieving this dual mandate. Let us look at the US context first.

In the case of the US, the high inflation was a case of temporary inflation that lasted longer than originally anticipated. Let us understand this better. During the pandemic, the supply chain constraints were created by the disruptions in China and, being at the centre of the global value chain, it had its impact on all goods and services. Supply was constrained in other economies too. However, the central banks attacked the pandemic slowdown with an unprecedented infusion of liquidity. This not only resulted in a lot of cash in the hands of the people, but also ensured that once the pandemic issues were addressed, the demand bounced much sharper than expected. In fact, the inflation was actually caused because the supply could not keep pace with the demand. Eventually, it was the same supply chain issue that got rectified over time and brought down the inflation. Ideally, the spike in interest rates at a rapid pace should have impacted and jobs. However, jobs were not impacted as the revival meant that demand for labour was far in excess of supply, which kept wages high. At the same time, the surfeit of liquidity in the market also ensured that consumer demand remained robust despite high inflation, and it was supported by high wage levels.

How was the situation in India. Actually, luck played a role in the Indian context also. Like the US case, even India is largely a domestically driven consumer market. The liquidity infused by the government and the low interest rates till the start of 2022 ensured that households and corporates had access to substantial funds at low cost. In addition, the demand contraction fears, and later the hard landing fears globally let to a sharp slowdown in the price of most commodities. This came as a big boon for Indian companies as they could see their operating margins staying robust, despite pressure on the top line at multiple levels. Also, one must not forget that Indian households are the biggest holders of gold, with more than 23,000 tonnes of gold in Indian households. With the price of gold reaching all-time highs in the aftermath of the pandemic, there was tremendous unleashing of the wealth effect on Indian households. That shielded them  from a lot of uncertainties.

Yes, there was a conscious strategy too

However, it would be naïve to dismiss the achievement of the dual mandate entirely on chance. There was a conscious recovery strategy at play too. Let us first look at how the US planned this dual mandate.

For a long time, the US has been trying to improve its labour participation rate, but had not been too successful. The US allowed work from home (WFH) as a conscious strategy to ensure that travel does not have an impact on productivity. However, this had the salutary effect of bringing more people into the workplace by decoupling the company and the workplace. That surge in labour participation also meant a surge in productivity and that ensured growth would pick up much faster than originally expected. The major focus of the US on artificial intelligence as a tool of productivity has also played a big part of this revival. Now, the companies are able to generate higher output and outcomes with the same resources as in the past. This has been a key reason for the robust growth and labour numbers. The focus on liquidity and rebuilding demand also helped to a great extent. But, there was one major strategy of the US Fed that really helped achieved this dual mandate. The decision to start aggressive rate hikes in 2022 was a factor in preventing a housing bubble from developing in the US market, of the kind we saw in 2006. The rapid rise in rates resulted in a 15% fall in residential investments in 2022 and flat growth in 2023. While this remains a pain point in the US recovery, it did prevent a housing bubble. Also, the pandemic led to the US focusing more of its manufacturing of value added products like semiconductors and EV batteries, where the supply chain constraints were not elevated.

What was the conscious strategy adopted by India to drive this dual mandate? Indian conditions are relatively different compared to the US since the vulnerability to food inflation and fuel inflation is much higher here. Indian policymakers addressed this problems on two fronts. Firstly, on the growth front, the government decided that it was time to make the fiscal deficit productive. Hence, the capex outlays were substantially increased, growing by 30% for 2 years in a row and by 11% in third year. These investments not only revived the capital cycle but also had a huge multiplier effects due to the downstream impact of these infrastructure outlays. Secondly, there was the big concern on the oil inflation front, especially after the Ukraine War. India made a conscious decision to substantially enhance their oil imports from Russia at discounted prices; and this avoided any surge in imported inflation into India. After all, India still relies on imports for meeting more than 80% of its daily oil needs.

Getting the policy prescription right

India and the US were the only two major economies to be able to achieve this dual mandate of controlling inflation without letting the growth situation or the jobs situation go out of hand. UK and EU have followed a very hard-nosed hawkish stance, but both are struggling with growth and unemployment. On the other hand, Japan and China kept their rates low through the hawkish journey of the US and the rest of the world. However, Japan has also dipped into a mini-recession with two consecutive quarters of negative GDP growth. Clearly, it is not so much about the hawkish of dovish stance as it is about how the managers of the economy manage these economic disruptions. In that direction, the US efforts and the Indian initiatives do stand out for managing to achieve something that almost appeared impossible even a year back. They have successfully contained inflation without letting the miasma of weak growth or unemployment dictate the narrative!