Challenge for global central banks: Uneven economic recovery vs inflation 

The conundrum for central bankers in setting policy is whether to acknowledge the more permanent nature of inflation and withdraw accommodation faster or keep policy accommodative for the unevenness in economic recovery to correct and hope that inflationary pressures would gradually dissipate. 

So is the inflation transitory? 

There has been a lot of debate over the last few weeks about whether the current inflation is transitory or not so transitory. There are definite signs that the inflation is more entrenched and durable than was earlier believed. 

Below are the 10y inflation expectations heading into the pandemic and current 10y inflation expectations for US, UK and Germany: 

US: 1.80% -----> 2.64% .

UK: 3.3% -------> 4.18% .

Germany 1% -----> 1.90% .

What is driving inflation? 

There is a confluence of several inflationary forces at play: 

1) Underinvestment in capacities over the last decade and a sudden surge in demand (i.e. Pent up demand) leading to imbalances.

2) Push towards green energy (Greenflation).

3) Supply chain disruptions as a result of pandemic.

4) Ongoing Transformation of Chinese economy: Rising labor costs, higher Industrial energy costs and stronger Yuan. China had been exporting deflation around the world, now it is driving inflation. Moreover, China has imposed restrictions on exports of certain fertilizers, which can drive food inflation as China is a major exporter of Phosphatic Fertilizers. 

5) Brexit (in case of UK economy): Shortage of low skilled labor.

Several of the above factors are structural and can cause inflation to persist. 

Also the diffusion index of inflation which shows the percentage of goods or services seeing above trend rise in prices is increasing. This suggests that inflation is more broad based. 

Why is inflation a threat? 

Persistently higher inflation can dampen demand in tbe economy and lead to a slowdown. A dreadful phase of high inflation and low growth can ensue (Stagflation) which is a nightmare for policymakers. 

How is inflation driving asset classes? 

Commodities and commodity linked currencies have been outperforming. Several commodities are trading at multi year highs. Currencies of commodity dependent countries have come under pressure. Higher inflation has pushed nominal yields higher and caused a sell off in bonds

Higher Inflation has kept real rates low. Lower real rates have fuelled rally in riskier assets such as equities and have supported gold prices. 

Why is it important to look at real rates? 

Usually when inflation is stable, one can look at differences in nominal yields to form a view on currencies but when inflation expectations are volatile, one needs to look at real rate differentials. This explains why the Dollar has struggled to strengthen meaningfully despite 2y yields rising by over 20bps, 5y yields by close to 50bps and 10y yields by over 25bps over the last few sessions. The Euro has underperformed as Europe is heavily dependent on natural gas for it's energy needs, prices of which have sky rocketed, resulting in high inflation expectations and low real rates. 

Countries which would be able to successfully contain inflationary pressures would see their currencies appreciate as real yields in those countries would move higher. 

How is India placed in this growth vs inflation theme

The minutes of the RBI monetary policy released yesterday show that MPC members are concerned about uneven economic recovery too. However several MPC members have also expressed concern over inflation. 

The RBI despite continuing to maintain an accommodative stance has been sucking out liquidity on a more durable basis. The cut off on VRRR (Variable Rate Reverse Repos) which was around 3.40% has moved to 3.90% over the last few weeksq i.e. from being close to reverse repo rate to being close to the repo rate. The operating rates are therefore moving higher but the question is whether that is enough given where the crude prices are and where CNHINR is. If crude prices retreat from current levels, it would definitely be a huge relief for INR as expected real rates would rise. 

The RBI therefore has a delicate balance to maintain between tightening policy too soon (and thereby exacerbating the unevenness in recovery) and keeping inflationary forces at bay. The way forward for INR would depend to a great extent on who emerges victorious, the RBI or inflationary forces.

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