Since early 2021, bond markets have been fearing an inflationary upsurge. It took a war to bring that fear into our drawing rooms. Inflation is likely to outlast the war in Europe. Global oil and food supplies could take a while to normalise even if the war ends soon. Chip shortages may only intensify as a resurgence in Covid-19 cases disrupts supply lines in China and Southeast Asia. To top it all, the global turmoil has led to a dollar
Since early 2021, bond markets have been fearing an inflationary upsurge. It took a war to bring that fear into our drawing rooms. Inflation is likely to outlast the war in Europe. Global oil and food supplies could take a while to normalise even if the war ends soon. Chip shortages may only intensify as a resurgence in Covid-19 cases disrupts supply lines in China and Southeast Asia. To top it all, the global turmoil has led to a dollar rally, making imports dearer for countries such as India.
At 6.1%, India’s inflation rate in February was just above the target range of the Reserve Bank of India (RBI), but most economists expect the rate to rise further in the coming months, given that retail fuel prices were still low in February. More than the immediate surge in inflation, the danger lies in a sharp uptick in inflationary expectations. This means your landlord will expect a higher rental when you extend your lease. You will bargain harder for a wage hike, fearing a jump in rent and grocery bills. Your employer will try to pass on the rising wage and raw material costs to consumers.
To prevent such a doom loop, most central banks have already tightened monetary policy, or signalled their intention to do so. India remains an outlier in this regard, with RBI still maintaining an “accommodative” stance (more on this below).
A spike in inflation won’t impact everyone equally. Borrowers will be rewarded as inflation lowers the real value of their future repayments. Creditors will be hurt. Inflation hits bond investors directly as it reduces the purchasing power of a bond’s future cash flow. So, a surge in inflation tends to raise bond yields (lowering bond prices) even before a central bank tightens its policy rate (the risk-free interest rate paid for ultra-short-term debt), eroding the value of bond holdings. It is for this reason that bond markets maintain an eternal vigil on inflation.
The inflation impact will vary sector-wise. Commodity firms will enjoy the benefits of higher pricing power but firms higher up the value chain, such as auto companies, will find their profit margins crimped. Real estate firms were already grappling with a demand shock. Now they face a supply shock, with prices of steel and construction materials moving up. The farm sector is staring at higher prices of fertilisers and other inputs, which could feed into food inflation.
As always, poor workers in the informal sector will be hit hardest as their ability to bargain for higher wages is relatively weak, and they have no recourse to any inflation hedge. Senior citizens will also be hit hard as inflation erodes the value of their savings. Younger and richer citizens with a diversified portfolio will suffer less.
The biggest gainer will be the country’s largest bond-issuer: The government. The crunch in revenues over the past few years has led to a sharp jump in government borrowings, raising the ratio of public debt to gross domestic product (GDP). The government can choose to raise taxes explicitly to fund its deficit, bringing down its debt levels. Or it can allow inflation to rise, which will raise the nominal GDP numbers, improve tax collections (at least in nominal terms), and bring down the debt to GDP ratio (by inflating the denominator). As long as the government’s banker RBI, keeps interest rates in check, inflation makes it easier for the government to repay its loans.
In other words, inflation acts as a hidden tax. It is effective precisely because it is not seen as one by ordinary citizens. But economists see inflation as the most regressive tax since it lowers the consumption of the poorest households. Former RBI governor, YV Reddy, wrote in his memoirs that politicians tend to see inflation as a problem only when it is in double digits. Till then, it may not be electorally salient.
The critical chokepoint for the government is the bond market, which can throw tantrums when faced with a supply glut. So, the government relies on the good offices of RBI to ensure an “orderly evolution of bond yields”. Keeping an accommodative stance is a key component of RBI’s strategy to manage this tension. In other words, the high levels of government debt limit the autonomy of RBI in using monetary policy tools to fight inflation; a phenomenon economists describe as “fiscal dominance”.
In his 2020 book Quest for Restoring Financial Stability in India, financial economist and former RBI deputy governor, Viral Acharya, wrote that fiscal dominance is the “theory of everything in India” that can explain much of RBI’s actions. The unusually high level of fiscal dominance today is a key reason behind RBI’s extraordinary monetary stance.
When RBI’s forecasts suggest it could miss its inflation target in the coming months, its refusal to change its monetary stance compromises its inflation fighting credentials, the lone dissenter in RBI’s rate-setting panel Jayanth Varma warned recently. If people sense that RBI is not serious about fighting inflation, it will only heighten inflationary expectations. The battle against inflation will become much more daunting in the future. RBI could end up being the biggest loser in such a scenario.
Pramit Bhattacharya is a Chennai-based journalist
The views expressed are personal
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