The current macroeconomic environment in the world and India is a classic macroeconomic case study. One of the most challenging times and the best time to learn macroeconomics. I will focus my current writing majorly on the current macroeconomic situation in India. This is certainly the testing time for our policymakers as we face multifold but interrelated macroeconomic challenges. To list a few major challenges, we are currently facing are high inflation, capital outflow, rising US dollar rate, widening trade deficit, etc.
Each of these challenges is big and cannot be addressed in isolation. This is a classic case of policy conflict. I am making an audacious attempt to simplify a very complex situation. I hope the experts on the subject will forgive me if I miss out on anything. The high inflation is majorly supply-driven as the major reason for inflation is the rising cost of our imports due to rising global energy and food prices. The rising cost of imports is putting pressure on our trade deficit and hence it is widening. This could be compensated with the exchange rate as an import-reliant country we will benefit from a stronger currency. However, with the rising inflation in the US and other developed countries, the interest rates in these countries are set to rise which leads to capital outflow from developing markets like India. This is how the current problem is interconnected and complex.
Now the real question is about what to address first so that rest of the problems can also be taken care of. For the last three months, I have been arguing that India doesn’t need to increase its interest rates as supply-driven inflation cannot be handled with demand-side policies. I couldn’t understand why our central bankers would do that. I think now I can predict the thoughts behind it. The rising interest rates in India are more of exchange rate targeting than inflation targeting. As they increase the interest rates, India will be again in a competitive position to attract foreign capital and probably our macroeconomic fundamentals might help us further. The higher interest rates will improve the rupee’s value against the dollar which can help us reduce the widening trade deficit and act as insulin against rising global energy and food prices.
Though the solution seems simple it is coming at the cost of economic growth. The higher interest rates will suck out the liquidity from the economy which will result in a fall in domestic private consumption and investment. Government consumption is also out of the question as the pandemic has hardly left us any choice to spend. Though the stronger rupee will help us reduce our trade deficit it will negatively impact our exports.
In my opinion, the interest rate hikes should be swallowed as bitter antibiotic pills that can give us short-term protection against external attacks. However, in the long run, it is important to build our natural immune system by allowing domestic consumption and investments to play their role. Hence monetary policy must focus back on economic growth than inflation targeting as soon as it can.