The MPC dilemma – Is the output gap closing, incorporating inflation?

While each revision of monetary policy after periods of extraordinary countercyclical responses presents tough choices for an exit strategy, the next one will present a particularly difficult mix of trade-offs. Economic activity had been hit following the two-year series of public health responses of varying intensity during the Covid-19 pandemic, including a permanent loss of income. Just as signs of a recovery in February 2022 began to appear, with a gradual easing of restrictions playing into pent-up demand, the Ukraine crisis and the resulting sanctions and disruptions to global supply chains in energy and raw materials had an impact on both production and the price shock. India, being a major energy importer, is expected to be heavily affected.

Even before the geopolitical shocks, price pressures had taken root in developed markets, with near-unprecedented levels of inflation. In the United States, in particular, labor markets remain very tight, with concerns about inflation in prices, wages and assets becoming embedded in household expectations. The US Federal Reserve is now widely seen as “lagging the curve” and has signaled a steep tightening cycle, at least for 2022.

Inflation in India has also remained elevated since December 2019 and appears to be broadening in recent months. The crucial question before the Monetary Policy Committee will be the size of the output gap and the speed at which it can close in the coming months. RBI has done extensive analytical work on estimating potential output, the Phillips curve, and other measures of system slack. The RBI Deputy Governor, in comments late last year, had indicated that the production gap at this stage could take many years to close. At the same time, the Phillips curve – the trade-off between inflation and the output gap – had started to strengthen in recent years, implying that inflation had started to react to aggregate demand. Moreover, the inflation process has become sensitive to forward expectations.

All of this underscores the need to carefully consider the likely output gap under current economic conditions and how quickly it might close. This article examines some heuristic measures as indicators of deviation and slack in the system.

For starters, Axis Bank’s leading composite index of economic activity – constructed from 39 high-frequency activity indicators – shows a fairly steep rise in March, but that’s based on a select set of measures. of “immediate forecasting”, such as mobility and electricity consumption. , whose correlation with underlying demand appears to have gradually weakened over the pandemic months. On the other hand, indicators like the manufacturing PMI and GST collections suggest that activity levels are not weak.

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