$1.9 trillion US stimulus package to boost India growth, nudge inflation

President Biden's $1.9 trillion US stimulus package
A potential increase in country risk premia and the upward pressure on domestic yields caused by the US stimulus could tighten the domestic financial conditions.

By Anagha Deodhar

Impact of US stimulus package on Indian economy: The Joe Biden administration passed the American Rescue Plan Act of 2021 last week. The widely anticipated stimulus package is one of the largest in American history and is expected to boost US output growth sharply, not just in 2021, but in the coming years as well. While Republican lawmakers questioned the need for another large stimulus when the US economy was already showing signs of recovery, Democrats firmly supported it and delivered on one of their most important election promises.

What sets the US stimulus package apart from the previous packages is its focus on supporting consumption. The $1.9 trillion package focuses more on individuals and the government instead of businesses. In the March 2020 stimulus package, 31% of the provisions were for businesses, while 40% and 10% were for individuals and the government respectively. Similarly, in the December 2020 package, 37% of the provisions were for businesses while 37% and 9% were for individuals and the government. In contrast, 54% of the provisions in the March 2021 package are for households, 27% for the government and only 4% for businesses.

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Among the largest provisions of the US stimulus package is a $1400 per person stimulus checks costing $422 billion, extension of unemployment programmes with $400/week supplement ($246 billion), child tax credit ($143 billion), support to state governments ($195 billion), support to local governments ($155 billion), and funding for K-12 education, colleges and universities ($169 billion). After incorporating the impact of the latest stimulus package, the Committee for a Responsible Federal Budget expects the US budget deficit to reach $3.4 trillion in 2021 and $1.6 trillion in 2022.

Stimulus to boost US GDP growth to 6.5%

At $1.9 trillion, the stimulus package stands at 8.5% of US GDP. According to OECD, the stimulus is likely to boost US GDP growth to 6.5% in 2021, up from the December 2020 estimate of 3.2%. That is, the proposed measures could raise US output by 3-4% in the first full year of the package (Q22021 to Q12022), broadly equivalent to the estimated spare capacity in the US. It is also likely to result in substantial demand spillovers in key trading partners.

Payments to households, which account for 20% of the package, are likely to boost consumption immediately. Other measures, such as support to governments and tax credits, are only partly pandemic-related. Large fiscal stimulus combined with expected status quo on Fed funds rate at least till 2023 are likely to keep the economy humming in the next couple of years. In the near-term, US employment is expected to rise between 2.25-3 million at the end of 2021. Inflation is also expected to increase by around 3/4th percentage points per annum in the first two years.

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US stimulus could tighten Indian financial markets

US 10-year treasury yield has risen to 1.6%, a level not seen since January 2020. Yields in the US are likely to inch up further and some believe 10-year yield could hit 2% as early as second quarter of 2021. Inflation in the US is also expected to pick up sharply as the vaccination programme proceeds, the economy opens up and households’ spending power is bolstered by the stimulus checks.

As US treasuries get more attractive, emerging markets could witness foreign portfolio outflows. Although India may not get badly affected by this. Some factors such as potential increase in country risk premia and upward pressure on domestic yields could tighten the domestic financial conditions.

Global growth could boost India’s GDP by 50-60bps

The OECD upped its growth forecasts sharply after incorporating the impact of the US stimulus. It now expects global output to grow 5.6% in 2021, up 1.4% from its projection in December 2020. It expects the US output to grow 6.5% in 2021, out of which the stimulus is expected to contribute 3-4%. Countries/regions that have strong trade ties with the US — Canada, Mexico, China, Japan, and the EU are also expected to benefit from the stimulus. The stimulus is expected to boost Canada and Mexico’s growth by 50-100bps, and Euro Area and China’s growth by 25-50bps.

While India does not have strong trade ties with the US, it is still likely to benefit from the boost to global output from the stimulus. The impact of the US stimulus package on domestic growth is most likely to be felt through the trade channel. The RBI’s monetary policy report in October 2020 assumed global growth at 5.4% in 2021. The report noted that if global growth were to surprise on the upside by 100bps, it could push up domestic growth by 40bps. Before the stimulus, our FY22 growth projection for India was 10.5%. However, after incorporating the impact of the stimulus, we expect the Indian economy to grow 11.1% in FY22.

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Impact of US stimulus on domestic inflation modest

The US stimulus could affect domestic inflation through two channels: commodity prices and exchange rate. Global commodity prices have increased substantially in recent months, spurred by US stimulus expectations and faster normalisation of activity in China. Prices of several commodities including cereals, sugar, cotton, select oilseeds, select metals, Brent oil, natural gas, and select fertilisers have increased in double-digits in the past few months. While rapidly rising commodity prices are likely to fuel inflation in many parts of the world, inflation in India is less vulnerable to it. This is because, robust domestic food production is likely to largely insulate India from the impact of rising global food prices.

The threat to domestic inflation from rising global commodity prices mainly stems from two items: crude oil and metals. Sharp increase in metal prices pushed up domestic wholesale inflation to 27-month high in February 2021, although in past few days we are seeing deceleration in the pace of price increases. Metal prices, however, do not pose any major threat retail inflation. The threat to domestic retail inflation comes mainly from one commodity: crude oil.

In October 2020, crude oil averaged $41/barrel. The central bank, in its semi-annual monetary policy report, stated that 10% increase in crude oil prices could push up domestic inflation by 30bps. In the first half of March 2021, crude oil prices have jumped to $66/barrel, an increase of 60%. Hence, going by the RBI’s calculation rising oil prices could push up domestic inflation by 180bps. Monthly CPI data confirms the upward pressure on domestic inflation emanating from rising oil prices. Inflation in components that are highly correlated with crude oil prices such as ‘transport & communication’, diesel, and cooking gas have been recording double-digit inflation for several months.

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Falling food prices, however, have brought down headline inflation. Despite rising oil prices, India’s retail inflation is expected to ease progressively due to falling food inflation. CPI inflation is expected to remain comfortably within the MPC’s target band of 2-6% for most part of 2021. Moreover, if crude oil prices rise unabatedly in the coming months and more than offset the impact of falling food inflation, the government has the option of cutting excise duty partly to keep domestic inflation under check. Hence, we do not expect US stimulus-fuelled uptick in commodity prices to pose any major risk to India’s domestic inflation.

Another channel through which the US stimulus could impact domestic inflation is the exchange rate. Independent estimates of Exchange Rate Pass Through (ERPT) (i.e. the impact of change in exchange rate on domestic inflation) suggest that India’s ERPT coefficient for CPI is 0.15 over five months. That is, a 100bps change in exchange rate leads to a 15bps change in retail inflation over five months. Recent research suggests that post the adoption of Flexible Inflation Targeting, the ERPT coefficient has declined to 0.08 in FY20.

Hence, if the rupee depreciates against the dollar by 100bps, it is likely to push up inflation only by 8bps. This indicates that the impact of US stimulus on domestic inflation through the exchange rate channel is likely to be modest.

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Indian exports likely to benefit from US stimulus

Stronger growth in world output is likely to increase the demand for India’s exports to the world. Let’s focus only on countries/regions that are likely to benefit the most by the US stimulus viz. the US, Canada, Mexico, Brazil, the UK, Japan, European Union and China. These eight geographies collectively account for 28% of India’s exports while the US alone accounts for 16%.

Since the stimulus package is likely to substantially boost growth in the US and other countries which have strong trade ties with is, the stimulus is likely to increase demand for India’s exports. Moreover, since the stimulus package focuses on households, its boost to consumption (and hence American imports) is likely to be strong.

The upcoming Federal Open Market Committee (FOMC) meeting will be keenly watched by the market. The US central bank will release new growth and interest rate forecasts, the first after the stimulus package announcement. The market will also be keen to take cues from Fed Chair Jerome Powell’s press conference and his views on interest rates, growth and asset purchases.

(Anagha Deodhar is Chief Economist at ICICI Securities. Views expressed in this article are personal.)