Opinion With so many known unknowns in 2023, economic policymaking will need to be humble and nimble
Sajjid Chinoy writes: Economies will be beset by a plethora of “known unknowns” in 2023. In responding, policymakers will need to internalise the tightening of the past, while still grappling with the imbalances of the present, but acting and guiding for the future
The hawkish tone was particularly necessary to preserve hard-earned monetary transmission of past tightening. 
It may seem inconceivable to contemplate the notion that policymaking in 2023 could be more challenging than the last three years. Alas, what could be more demanding than responding to a once-in-a century pandemic juxtaposed with a war? As difficult as that was, at least the direction of travel was clear. The pandemic’s impact on output was so tangible that it necessitated a coordinated fiscal-monetary response. Similarly, the war-induced supply shock to commodities was so outsized that the imbalances it spawned — surging inflation and pressure on current account deficits — meant the policy implications were obvious. Fiscal policy had to buffer the impact on households and firms. But precisely because fiscal had to accommodate the shock, monetary policy had to go the other way. And in a hurry. Global policy rates have been hiked by about 300 bps — the most aggressive tightening since the 1980s.
So, what will make policymaking so challenging in 2023? Quite simply, the multiple cross currents at play. The impact of the pandemic and the war has meant emerging markets (EMs) are a sizeable 4-5 per cent below their pre-pandemic potential path (versus 1 per cent for developed markets). And this is before the sharp slowing of global growth in 2023 that we must brace for. Even in a relatively soft-landing scenario, global growth is expected to slow to 1.7 per cent next year from 3 per cent this year. The implications for growth, jobs and livelihoods in emerging markets are ominous. Ordinarily, policy should turn more supportive. Yet emerging markets will be constrained both because inflation and current account deficits (CAD) are still too sticky and because a high-for-long Fed could make EM easing fraught with risk.
Therein lies the conundrum. Should policy keep tightening to quell imbalances and break the back of inflation and current accounts but risk more scarring? Or gamble that slowing growth will have a curative effect on imbalances such that policy can slowly start getting more supportive? Precisely because the direction of travel is not clear, 2023 will be so uncertain and challenging.
How should policy react? By adopting two guiding principles. First, given the large and two-sided uncertainty, “optionality” should be embedded into next year’s frameworks, so that policy can quickly respond in either direction. Nimbleness notwithstanding, it will be very challenging to “right-size” the policy response amidst such elevated uncertainty. A second guiding principle should therefore be, when in doubt, err on the side of a Type 1 error (doing too much) vis-a-vis a Type 2 error (doing too little). Why? Because if policy is deemed to overtighten, it can be quickly and sharply reversed. But if too little is done, hardening inflation expectations can permanently worsen the trade-off between output and prices (that is, the Phillips Curve moves up) and unsustainable current account deficits can put pressure on currencies and FX reserves that can take on a life of their own. The cost of policy errors is therefore often asymmetric.
Central banks seem to be taking these lessons to heart. The optionality principle was recently used very effectively by the Fed and the RBI. Both downsized their rate hikes in December sending a dovish signal. To maintain optionality, therefore, it was imperative that the accompanying language was hawkish. The RBI, correctly stuck to its “withdrawal of accommodation” stance and emphasised the need to “keep inflation expectations anchored, break core inflation persistence and contain second round effects” while the Fed, against the backdrop of two soft core CPI prints, said it needs “substantially more evidence” of disinflation.
The hawkish tone was particularly necessary to preserve hard-earned monetary transmission of past tightening. If markets are convinced central banks are done, the impact of past tightening on rates will be quickly undone. It took one soft US CPI print for US 10-year yields to soften by 50 bps. In India, real bank lending and deposit rates are still much below pre-pandemic levels even as inflation and the CAD remain elevated, so the RBI will need all the transmission it can get.
For further monetary policy downshifting to be “time consistent,” central banks will have to keep markets guessing and monetary conditions tight enough to temper demand and bring down imbalances, to enable a future downshift. Else future economic conditions will render any current proclamation of a pause untenable and “time inconsistent.” For now, therefore, central banks will have to convince markets: “do as I say, not as I do…”.
Fiscal policy is more straightforward. In a year with acute fiscal constraints, authorities must be commended for recommitting to the budgeted deficit target. But even after achieving this, total public sector borrowing will be close to 10 per cent of GDP, necessitating sustained consolidation. The need to do so is best appreciated by understanding the link between the fiscal and the current account, which is tracking above 3 per cent of GDP this year. Recall, the CAD is simply an economy’s investment-savings gap, that is, the public sector borrowing requirement and the private sector’s investment-saving gap. The fiscal deficit understandably rose during the pandemic but because private savings surged and private investment retreated, the private sector could absorb large deficits without pressuring the current account. Now, as the private sector is recovering, (and its investment-savings gap is normalizing) a large consolidated deficit is spilling over into the CAD. For the private sector to continue, without pressurizing the CAD further, the fiscal must be tightened commensurately.
This, in turn, will require a deft balancing act as public capex spend will need to be sustained or increased even as the deficit is reduced. To be sure, fiscal consolidation will weigh on aggregate demand (unless accomplished entirely by asset sales). But the impingement can be mitigated by a continued improvement in the quality of expenditure (with capex’s larger multipliers) and by situating deficit consolidation against a credible, medium-term fiscal anchor, to help reduce risk premia across the yield curve.
Economies will be beset by a plethora of “known unknowns” in 2023. In responding, policymakers will need to internalise the tightening of the past, while still grappling with the imbalances of the present, but acting and guiding for the future. This will be a high-wired balancing act. To succeed, policy will need to be, in the words of Fed Chairman Powell, both “humble and nimble”
The writer is Chief India Economist at J P Morgan. Views are personal
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