Inflation became the latest buzzword, next only to Covid-19, in the latter half of 2021 for many economies, including India. Of all the countries, inflation in the US prompts the most compelling cause of concern because of its potential to create a more pronounced domino effect across all the emerging economies. Since the US is now gearing up to wage an active war against inflation, we present a simple exposition of what caused the spiralling US inflation and its potential impact on the Indian economy.
Understanding the US inflation
The US inflation breached the trend of four decades and rose to a record-shattering high of 7 per cent year-on-year (YOY) in December 2021 (i.e. the prices were 7 per cent higher in December 2021, relative to December 2020). The earlier explanation for the rising trend was that, much like other countries, Covid-19 induced lockdown brought about the unprecedented lockdown and halt in economic activity, leading to supply chain disruptions in the US. These disruptions translated to higher input prices and subsequently higher consumer prices and inflation. This is why throughout 2021, Fed has maintained that inflation is transitory and is the consequence of supply-chain distortions.
However, why are economists wary of classifying this is as transitory or supply-led inflation? Because one cannot ignore the role of demand. The lull in the economic activity during lockdowns was followed by rapid recovery, which was fueled by fiscal and monetary stimulus. This meant that the households had higher disposable income. Furthermore, because service sectors, like travel, hospitality, entertainment and restaurants were closed, the consumers spent more on goods. This led to higher demand for goods, relative to their supply. Because this inflation is both demand- and supply-led, it might be here to stay.
The pertinent question to ask is this- can this inflation be tamed soon? This is hard to predict given the pervasive labour market shortages in the US, the sluggish recovery of the Chinese economy and the uncertainties regarding the future Covid-19 waves. Since the second half of 2020, the labour demand has far exceeded the supply in the US. This means that the price of labour, i.e., nominal wage rates, has been going up. This has led the firms to pass on the higher labour cost to the consumers in the form of higher product prices. Even with the rise in job openings, the labour force participation rates are yet to reach the pre-pandemic levels. This phenomenon is forecasted to continue, contributing to higher inflation.
A similar argument can be drawn for supply shortages from China. China is the largest supplier of consumer and corporate goods to the US. The intermediate product prices in China, like metal processing, textiles, electrical machinery, etc. rose in the latter half of 2021. Subsequently, the final products made from the imports of these materials in the US got more expensive, and this higher price was borne by the consumers adding to the already rising inflation. Finally, the severity of the new variants of Covid-19 and uncertainties about future restrictions continues to plague the economy.
How does it impact the Indian economy?
The Indian economy has already witnessed a 5.59 per cent (YOY) inflation in December 2021. With the rise in global prices, India might import more inflation to its domestic borders since the cost of raw materials and other imported goods will become higher. Furthermore, the consequences will be different if Fed tried to curtail inflation in the US. To do so, it will want to control the money in circulation and undertake a tighter monetary policy. This will lead to higher interest rates. How? Higher interest rates make it more lucrative for people to keep the money in their savings account and makes it unattractive for the borrowers.
This might cause a ripple effect in India. The rise of interest rates in the US might attract investors to park their money in the US. This effect is called the 'beggar-thy-neighbour effect' in economics. Hence, foreseeing this behaviour, RBI might increase its interest rates as well. An increase in the interest rates in India too, translates to less money in circulation in the economy, implying that the rupee becomes more expensive, and the currency appreciates. An appreciated rupee would pose problems for the export sector and might end up hurting the revenues from exports and overall GDP. Hence, the central government might be against this policy measure. On the flip side, if RBI doesn’t undertake any action to control the money supply, it would not only lead to continued imported inflation but might also lead to capital flight to the US (a country with a higher interest rate), leading to loss of potential capital for entrepreneurial opportunities in India.
Conclusion
Given the current scale of globalization, India, along with other advanced and emerging economies, is witnessing similar trends in inflation as the US. While the mechanism with which the US inflation and its curtailment measures might impact India is explained above, we also keep in mind that the Indian economy is estimated to grow at 9.2 per cent (here) while controlling for the current trends in inflation. This might be because India has previously sustained a 6 to 6.5 per cent GDP growth with a 5 per cent inflation and is currently in a robust position (here).
(Payal Seth is a PhD Scholar at Bennett University and Palakh Jain is an associate professor at Bennett University. )
