Distant Thunder in the World Economy

Context: While we’re in the happy period of the global economy coming back to life, we need to watch the US inflation situation in the post-pandemic phase carefully.

Factors controlling capital inflows:

• Capital flows to emerging markets (EMs) are shaped by “push” and “pull” factors.
• “Push” factors are low-interest rates and low risk in DMs, which guide institutional investors in DMs to obtain the higher rates of return available in EMs albeit while bearing higher risk.
• “Pull” factors are the economics and politics of the EMs: The prospects for sustained growth and for low correlations with international portfolios.

Challenges to the Indian economy:

• Declining macroeconomic indicators: Things are looking difficult with household demand, government demand, and private investment demand.
• Inflationary indication from the US: Some brief inflation may be an inevitable part of the reopening.
  • Each firm and each individual makes economic decisions such as restoring operations at full scale and doing labour supply.
  • These decisions are made in a decentralised way: Each economic agent thinks and acts alone, without coordination with others.
  • For e.g. when the coffee shops reopen, the coffee bean producers may not be ready. The price of coffee beans will go up. Thus, reopening decisions are coordinated through the price system.
  • While such a phenomenon is easily controlled by the central banks, through inflation targeting, the unpredictable attempts by the US Fed to control the capital inflows have an adverse impact on the Indian economy (as witnessed in 2013 through ‘taper tantrum’).

Bright spots in Indian recovery:

• Rising export demand: The world economy is recovering strongly, as prosperous countries were able to bring their high state capacity to bear on vaccination.
• Change in the US’s politics: In the US, a euphoric recovery has come about, through the reduction in the political influence of Trumpism, through vaccination, and through fiscal policy playing on a World War II scale.

Way Forward:

• We in India need to watch carefully and develop a point of view on five questions.
  • By late 2021, what will the inflationary situation in the US look like?
  • Will the US Fed start getting concerned about the resurgence of inflation?
  • Will they successfully manage their communication strategy when the time comes to change course, thus avoiding the problems of the taper tantrum?
  • When the outlook for DM inflation and interest rates changes, how will this impact asset prices, and capital flows into India?
  • How will the RBI stay focused on its inflation target through these events?