Here’s what ‘Hard’ vs ‘Soft’ landing means for policy choice before central banks in both US and India

Next year, in April-May and November, respectively, India and the US will each hold significant elections. For Narendra Modi and Joe Biden, it would be important to see how their economies perform this year and in the months leading up to the election in terms of growth, new jobs created, inflation, and real earnings.

From this angle, there are causes for alarm in the official economic numbers for the two nations that were released this month.

Let’s start with the figures for consumer inflation in the US, calculated using the Bureau of Economic Analysis’s personal consumption expenditures (PCE) price index.

The PCE price index as a whole increased 5.4% in January compared to the same month in 2022. Core PCE inflation, which does not include changes in consumer energy and food costs, which are more prone to volatility, was 4.7% on an annual basis.

The US Federal Reserve’s goal inflation rate of 2% has been consistently exceeded by both “general” and “core” inflation. While the latter, which is thought to be a more accurate indicator of the underlying inflationary trend in the economy, has been steadfastly stuck at around 5%, the former has dropped from its peak of 7% in June (Chart 1).

The shocking finding from the PCE price index data released on February 24 isn’t the year-over-year inflation (Jan 2023 over Jan 2022), but rather the month-over-month inflation (Jan 2023 over Dec 2022). Prices rose 0.6% over the previous month, which translates to an annualised rate of 7.2%. According to Chart 2, both the general index and the core index experienced their greatest monthly increases since May.

The aforementioned information should be viewed in conjunction with a prior US Bureau of Labor Statistics report on the employment situation, which was published on February 3. The largest since the 568,000 in July, it revealed that total non-farm payroll employment increased by 517,000 in January as opposed to a monthly increase of 401,000 in 2022.

In addition, the jobless rate dropped to 3.4% in January, the lowest level since May 1969.

The January employment and inflation numbers indicate two things.

First, inflation has increased again after appearing to decline towards the end of 2022, albeit even those figures were far higher than the US central bank’s target of keeping the PCE price index increase at 2% annually.

Second, declining unemployment has made the Fed’s work more difficult since it shows that labour demand is outpacing supply. The tightening of the labour market, which Fed officials see as becoming “out of balance,” is pushing up wages and, as a result, inflation.

What action does the Fed take? It has no alternative but to increase interest rates further given its commitment to maintaining price stability and bringing inflation back down to 2%. Businesses and consumers will hire fewer people and spend less as borrowing costs rise. Thus, a slowdown in economic activity would lower demand overall, aid in cooling overheated labour markets, and eventually bring inflation under control.

But, it is crucial to remember that the Fed has already significantly increased its funds rate, from a target range of 0-0.25% through March 16, 2022, to 4.5-4.75% at the most recent Federal Open Market Committee meeting on January 31–February 1.

A harder landing, as economists refer to it, would be at danger if you continued hiking. Interest rates must be raised quickly and significantly when inflation is consistently over the target level of 2% (5%), and they must be maintained there until the pace of economic growth slows down sufficiently.

In the run-up to the US presidential elections, that would imply a severe downturn or recession. It is the antithesis of muted growth or a mild recession (“soft landing”), which occur as a result of the Fed raising rates slowly and incrementally to bring inflation down from, say, 3% and cool a not overheated economy.

The yield on US 10-year government bonds serves as a leading indication of interest rates. These, which are essentially what the government would pay for a 10-year loan, have increased from 3.40% to 3.95% between February 2 (before the jobs data) and February 24. Clearly, the markets have factored in the Fed’s anticipated considerable tightening of monetary policy.

With the consumer price index (CPI) inflation’s downward trend reversing in January, the Reserve Bank of India (RBI) is in a similar predicament. According to its mandate, the central bank must maintain annual CPI inflation at 4%. Although though this aim is less stringent than the US Fed’s 2% and is subject to a “upward tolerance limit” of 6%, both general and core inflation levels were violated in the most recent reported month.

The impact of above-average temperatures on wheat and other rabi crops, which are scheduled for harvest beginning in March, is now the biggest source of worry for the RBI. If temperatures continue to rise, as they did in March of last year, food inflation may resume. However, it indicates that rural wages are starting to improve as of November, when the average rate of growth over the previous year surpassed CPI inflation.

The RBI has increased its benchmark repo lending rate from 4% to 6.5% since early May 2022, following the Fed’s lead.