After emotional outburst of last week. It is time to digress a little bit and write about a subject which is very close to my heart. Last week, after a surprise announcement by RBI to hike the short term interest rate, financial news had been laden with critical assessment of RBI act. Terms like "lagging the curve", "hard landing" have been used too often, without clarifying the terms or the underlying assumptions. Even if I accept the fact that target audience for these articles are very smart, intelligent and financial jargon savvy, I cannot stop wondering how many people who write these articles can go beyond the normal rhetoric and explain "What is hard landing?"
In my search to understand the landing problem of the economy, I stumbled upon a much more basic and much more interesting question "Why are the central banks world over obsessed by Inflation". If you think about it inflation is just an adjustment to prices, what difference does it make if it is 2% or 10% or 100% (Apart from the fact that 100% looks little scary) net net at the end of year maths will work out and all that would effect us would be growth in real terms. For ex - Suppose inflation in economy is running at 10% for past decade, commodity prices (raw material) on an average will rise by 10% every year, corporates will be forced to increase prices by 10% every year, wages will go up on an average by 10%, borrowers will benefit by paying less money on the older loans but lenders will benefit by charging higher interest rate going forward. In essence, If there is no real growth in the economy, more or less everything would be same. So why is there such a hue and cry about inflation after all? Not just common people, economist world over are obsessed with inflation to the extent that some central banks have been mandated to manage inflation.
Only answer which makes sense to me is that inflation as such is least of anyones concern, surprised, may be I am wrong but central banks world over are worried about fluctuation (volatility) in inflation and markets expectation of inflation, which amounts to almost the same thing. If there is no volatility or fluctuation expectation will always be well anchored. Consider the same example I mentioned earlier and imagine instead of being constant at 10% inflation varied from 2% to 20%. Can you at least foresee the problems faced by you and your employer, how much wage appreciation should be there in the economy, how much price increase corporation should plan for, how much price rise should household plan for. The whole economic system will eventually be in chaos because no one will know what to expect (which is anyway the situation in India but it can be much worse), people will have to spend a lot of energy in hedging inflation instead of pursuing productive activities.
Does this mean RBI is foolish in raising interest rate when inflation rises, shouldn't they wait to see if volatility goes up or not. Absolutely not, last and final piece of this puzzle is, inflation in general tends to be more volatile at a higher base. So, central banks world over start raising interest rate as soon as they see sign of inflation gaining momentum, since there is a time lag between the act of raising interest rate and impact of raising interest rate on inflation. Analyst use the term lagging the curve to signify that increase in interest rate is late or insufficient to contain the momentum in inflation. Also, as I have already mentioned higher inflation leads to higher volatility, which leads to higher uncertainty it is not far fetched to assume that this can lead to a vicious circle of rising inflation and rising interest rate which can eventually lead to decrease in economic activity. It is this curtailment of economic growth by spiraling inflation which is considered as "hard landing".
A remarkable improvement from your first post in terms of language and presentation. A good topic to talk about. I don't agree with a lot of what is being said though :) Hyper-inflation is dangerous and deflation is a hindrance to any economy. Hence inflation needs to be kept at manageable levels.
ReplyDeleteYaar...first thought was "it is quite boring not something I would like to read."
ReplyDeletebut when i read it later I felt it is a great analysis, an act of genius....
But at the same time I feel you have kept yourself confined to the big corporates and their employee. Economies have farmers, agricultural products, self-employed professional like CA, CS, Doctors and so on...Indian economy have people who do pure manual labor like construction workers.....what food inflation of approx. 18% for past one year have done to these people...
so good material for grey cells...
The point on inflation expectations is well made. As you say, it can dictate economic decision-making, which is why central banks watch it so closely.
ReplyDeleteAs you know, the primary criticism of inflation is that it imposes a cost on bondholders/lenders/savers - future cashflows are worth less if inflation is higher/increases during the life of the bond. (Central banks are independent of the government precisely so that governments will not issue bonds, spend freely and then inflate away the debt.)
Of course, like you say, if it is known ahead of time that inflation will be 10%, then the bondholder just has to demand a yield that is 10% higher at the beginning - problem solved. But I think when inflation is high it is also more variable - so then like you say it's harder to form expectations. More generally, since inflation is only known a posteriori, economic agents will find it harder to interpret price changes and respond (i.e. are things more expensive because of inflation, or because of demand/supply forces).
The other thing of course is what high inflation means for the exchange rate. Purchasing power parity says the currency of the high inflation country will depreciate, which has a host of attendant consequences.
With regard to food prices in India though, it must be noted that inflation, in the context of monetary policy, is a rise in the general price level i.e. it affects all goods and services. That's because it's fundamentally a monetary phenomenon (famous quote by Friedman). The rises in food prices occurs for different reasons - I think primarily supply side factors. For eg, I read when I was in India that it costs on average Rs 7 to transport Rs 1 worth of rice from Punjab to other parts of the country (probably in part due to high oil prices these days). To that end, I'm not sure how much RBI can do with interest rates (though maybe revaluing the INR will make oil cheaper). The Indian government will have to use other means to correct this misallocation.