Monetary policy might need a new operating paradigm. For one thing, it needs to accept the fact that the world now operates in a state of what economist Michael Spence terms “permacrisis”, a continuous series of shocks that affect the global and the Indian economy. These stem from a myriad of factors ranging from climate change to military conflict to the restricted access to critical inputs from rare earths to solar cells and manufacturing equipment. 

These are not textbook “supply shocks” that are largely assumed to be transitory and give policymakers scope to look through them in formulating policy responses. Take the conflict in the Middle East that was initially expected to be over in a few weeks but has now dragged on for a good seven months, with the risk of it prolonging indefinitely.

Permacrises present two problems.

It compromises the supply side and introduces a long-term inflationary bias in the global economy. This should, de facto, lead to elevated inflation expectations even in periods of respite from a shock and drive precautionary behaviour among consumers and producers. Precautionary behaviour, in turn, could reinforce the inflation bias. 

A household that saw a spike in foodgrain prices due to unseasonal weather might find it imperative to hoard foodgrains in anticipation of another freakish spell of weather. Firms could “overstock” inputs if they fear supply shortages in future.

The second problem is that the supply side has started to have a rising share of impact on headline economic data like GDP or industrial production compared to demand. Take the case of the recent unseasonal rains or flooding in Thailand that economists predict could shave 0.1 to 0.3% off the previously forecasted median GDP growth of 2.3%.  

Estimates of the impact on Indian industry of difficulties with sourcing intermediates from China—one could view this as a prolonged supply shock—are sparse.

This impact on sectors ranging from electric vehicles to pharmaceuticals to defence and telecom equipment, to name just a few, is however likely to be significant. The performance of these sectors can wax and wane depending on prevailing Sino-Indian relations and China’s export policy.

Output Loss
These supply disruptions do not operate only through the supply side. They have an impact on output and, by extension, demand. If a telecom manufacturer cannot operate at its desired capacity because of a shortage of intermediates, its topline suffers. This then seeps into the demand for other raw materials, labour and working capital.

The source of output destruction is not a demand shortfall as we know it, but a restricted supply of the means of production. If the input shortage manifests in higher prices for the finished product, prices could rise, and output could decline. This challenges the neat inverse relationship between output growth and price rise. Monetary policy that primarily operates on the demand side is likely to be caught on the wrong foot.

This creates and raises a whole new set of challenges and questions for the RBI. If indeed Permacrisis creates a medium- to long-term upward bias in inflation, should the central bank adjust its inflation target upwards and accept higher inflation as an inevitable consequence of an altered supply scenario? Instead of fixating on getting inflation down to 4%, should it set a higher target of 5% or more?

On the other hand, if it sticks to the 4% target, its so-called “reaction function” might need to change with more monetary tightening at the slightest hint of price levels rising. The recent monetary policy did well to separate and comment on supply-side driven inflation pressures and second-round effects of inflation. Its assessment was that “there are limited signs of supply-side pressures getting embedded in pricing behaviour.”

What does this imply? If the central bank had found that both components had been impacted by the energy shock, would a 50-basis-point rate hike have been optimal instead? Does it now also need to consider contractions in output due to non-transitory supply problems and arrive at a balance?

These new trade-offs and related dilemmas stem from bigger forces at work. For one, the hard laws of macroeconomics have been replaced by the calculus of geopolitics in determining global economic trends.

The growing polarisation of global politics has given multilateral concerns like climate change short shrift. The uncertainty surrounding the possibilities that AI presents has driven a misallocation of capital. The turmoil that all these forces put together have led to a state of constant flux. Neither fiscal nor monetary policy can afford to ignore these changes.  End