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Even as RBI hikes interest rates, the Indian economy can almost certainly not fall off the cliff

The Reserve Bank of India (RBI) hiked rates by 50 basis points (bps) in its bi-monthly monetary policy on August 5, in line with its aggressive strategy over the past couple of months to tame domestic inflation. While this would have disappointed some sections of the market, RBI stuck to the conventional central bank playbook. With retail inflation printing above RBI's tolerance limit of 6% for the sixth straight month, and unlikely to go below this until February 2023, its decision seemed to be for the course.

RBI is not alone. Central banks across the world are waging a crusade against runaway price increases. For example, the Bank of England hiked rates by 50 bps, a day before RBI. Its prognosis was dire - consumer inflation in Britain could rise to 13% by the year-end. The US Federal Reserve has already hiked its policy rate by a mind-boggling 2¼ percentage points since March. More increases are due as the US' preferred gauge of inflation - the personal consumption expenditure, currently at 6.8% - is unlikely to come closer to its target of 2%, anytime soon despite aggressive rate hikes.

The problem is that free lunches are rare in economics. Interest rate hikes take a toll on economic growth and hefty hikes come with the risk of triggering a recession. The Bank of England has warned of a recession by the end of the year, and the majority of pundits in the US suggest that the Fed cannot tame inflation without beating the living daylights out of economic growth - a deep recession, for short.

So, as RBI hikes rates, could the Indian economy fall off a cliff? Almost certainly not. This is where the difference in the underlying economic situation between India and some developed economies comes into play.

  • The output gap - the amount by which the actual output of an economy deviates from its 'potential output' - is negative in India (some estimates put it as high as 3%), while it is positive for the US and less negative for other developed markets.

This implies that in the US, for instance, overall demand for goods and services is greater than supply. In India's case, a negative output gap suggests that most of the inflationary pressure is still supply-driven. Supply shortages can persist for a while, but are less potent than excess demand in embedding long-term inflation pressures.

  • The labour market - on the whole, or at least parts of it - is very tight in developed markets. The US unemployment rate is at just 3.5%.India's is 6.8% - 6.14% for the rural economy and 8.21% for the urban, according to the Centre for Monitoring Indian Economy (CMIE).

A Wager on Wages

The labour shortages in the US have largely come on the back of full-scale reopening post-Covid, as the impact of massive fiscal stimulus coupled with easy money kept under a lid by curbs on activity have now hit the job market. India's parsimony in giving fiscal support during the pandemic (a meagre 3.5% of GDP compared to 25% in the US) seems to have paid off in managing inflation.

The mega comeback of the services sector has suddenly found developed economies desperately trying to fill vacant positions in sectors like tourism and aviation. The only way to do this is by hiking wages, setting off a typical wage-price spiral. India's vast labour pool has prevented this from taking root.

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