Inflationary pressure

Fiscal expansion increased inflation in the developed world

It’s been over four years since the pandemic began spreading across the world. The first lockdown in India was imposed on March 24, 2020. Restrictions on mobility in practically every part of the world to contain the spread of the virus severely impacted output and employment. As a result, governments and central banks adopted policies to support economic activities and minimise the damage. An improved understanding of the virus and quick availability of vaccines at scale helped revive economic activities. Global recovery from the pandemic has been far stronger and more resilient than initially anticipated, partly because of the strong performance of the US economy. The Indian economy has also recovered strongly and is projected to post a 7 per cent-plus growth rate for the third consecutive year in 2023-24. However, robust output recovery was accompanied by high global inflation, increasing economic risks.

When the inflation rate started inching up in the initial phase of the recovery, central banks, particularly in the advanced economies, treated it as a temporary phenomenon emanating mainly from supply-chain disruption during the pandemic. The Russian invasion of Ukraine in early 2022 further disturbed supply chains and pushed up the inflation rate. Consequently, large central banks, including the US Federal Reserve, started increasing interest rates. By mid-2022, the inflation rate was nearing the double-digit mark in the US. This led to the fastest increase in policy rates by large central banks in decades, resulting in significant volatility in financial markets. While supply-side disruption was indeed one of the reasons for the sharp increase in inflation rates, it is argued that aggressive stimulus in different parts of the world during the pandemic also played a part. New research by economists at the Reserve Bank of India (RBI), published in its latest monthly bulletin, looks into this aspect and can be useful for future policy management.

Notably, policy responses to the pandemic varied significantly across the world. Advanced economies accounted for nearly 80 per cent of global fiscal response, which was directed mainly towards direct transfers to individuals and families in different forms. Strong fiscal support also enabled faster economic recovery. The RBI study of 13 countries, including India, showed the relationship between fiscal intervention and inflation to be stronger and more visible in the post-pandemic period. Thus, countries with a larger fiscal stimulus witnessed higher increases in inflation rates and those with moderate support witnessed moderate inflation outcomes. Fiscal support in India was relatively limited and targeted. Although inflation in India remained elevated during the recovery phase, the increase was not as sharp as in the developed world, partly because it was on the higher side in India even before the pandemic.

It is argued that the fiscal deficit will be inflationary in India only if it is at full employment, or when there are supply bottlenecks in certain sectors. While the core inflation rate in India moderated significantly and is close to the target, supply-side issues, particularly in the food basket, have kept the inflation rate up. Nonetheless, the result of the study underlines the importance of measured fiscal intervention and timely reversal. The fiscal policy in India is focusing on capital expenditure to support growth. While India needs large investment in infrastructure, a low and stable fiscal deficit will help support the objective of sustainable growth with price stability.