Tuesday, June 13, 2006

Inflation and Interest Rates

How stupid for Times of India to advise USA Fed to go slow on it’s interest increase policy! American Congress and CEO – President – never dare to advise Fed about it’s policy and here is a news paper of a seemingly bullish nation admonishing Fed about it’s policy. Are we in the Globalized world or is it a usual sign of Indian Media shooting where it does not belong? Or is it the desperation in world markets about the impeding rapid changes? Looks like last is the case. Sometime back Time of India Editorial admitted that it will wrong for them to give economic advise to Indian PM and Finance Minister; the accomplished duo of economists. So may be TOI better shut it’s mouth in regards to all economic policy matters.

Below is a table which indeed shows the turmoil going in world markets.

Table 1: % change in global markets
Source: http://www.frontlinethoughts.com/article.asp?id=mwo060906)

Wall Street is not free of these declines too. During the period Dow Jones is off around 6.4% from its high and the NASDAQ is down by 10%. Looking at the recent numbers (NASDAQ falling by 2% yesterday and Bombay Stock Exchange under lot of ‘red’); it is clear that this decline is still work in progress and it may continue for a while.

So what is happening and why TOI is shouting at Fed to stop increasing the rates? The latter part is easy since it hurts Indian Economy and any emerging economies in general. RBI and every other central bank have to increase interest rates and it works as a brake on the high growth.

The why part is tough to answer. Before one goes to that, it should be noted that TOI and anyone who argue for stopping the interest rate increase misses the single most important point – mandate of Fed and any Central Bank in ‘fiat based currency world’ is controlling inflation. (Or else what is the value of your paper currency?) Low numbers people site of inflation are misleading. Fed, Bond Market and most traders know that inflation is increasing and only fool can undermine its danger. Given that, there is natural proclivity for Fed to ‘overshoot’ in terms of rate increase rather than fail to control inflation. Easy money supply due to lower rates fuel asset and overall inflation and the solution is to ‘mop up’ the liquidity. September 11, 2001 and Dot Com bubble made Fed to open the spigot and lot of money was printed. It was done with the view of kick starting the economy by easy borrowing when deflation was the scare and there were no signs of inflation (classic business cycle lows – abundant availability of labor and weak demand for commodities). Now that part is done, there is no reason to keep this easy policy.

So far last four years, cheap labor of India and China hold the inflationary pressures in a way. But increased prosperity in these countries is adding to the global pressure on commodities including Oil and the first part of inflation is set in – higher material cost. As the pool of people in USA, Western World shrinks; it was thought that Billion plus population countries like China and India would not create any labor shortages. But with increased income in these countries and larger availability of opportunities have also made labor expensive in these countries. So not only USA labor but labor in emerging economies is also turning out to be expensive. So the second part of global inflation is set in – tight labor market.

With these conditions set, inflation gene is out and Fed must control that. Initially, due to sloppy job of ‘market signaling’ Fed kind of gave the impression of ‘Bernanke Printing Press’ and now market, especially bond vigilantes, want the proof that Fed will be hawkish. Hence Fed is trying to ‘talk’ the market and has cornered itself in a position in which it has to increase rates to protect its ‘inflation control’ mandate and eventually its credibility. It can very well afford a recession, but cannot afford the market to have impression that it does not bother about inflation. Inflation is bad because with that price stability is goes away, asset value drops, eventually growth stunts and decrease in living standards set it. Until the job of mopping the excess liquidity is done, Fed cannot entertain ideas of reducing the interest rates to invigorate the economy.

When will this job of taming the inflation done? Hard to know exactly. But one is looking at slower USA economy in the second part of this year which can help to contain the inflation in certain measures.

The question is whether it will be a hard landing or soft. It is likely to be hard landing, but relatively long term robust global demand due to new engines of China and India can potentially avoid this hard landing or will at least make it little bearable than a deep recession. If dollar does not hold (due to increased borrowing costs to USA Government increasing it’s fiscal deficit large and slowing economy halts the encouraging trend of deficit reduction); then again it will be hard landing. But if increased interest rate pops up dollar for a while; one can hope for soft landing. The third possibility of stagflation (no growth and high inflation) does not seem possible since chances of Fed and Central bankers around the world taming down inflation eventually are quite high.

There is no escape from some economic pain ahead. The extraordinarily stimulative policies of last few years are bound to end and prompt changes. That is what is happening now and all need to adjust. That ‘change’ is what TOI wants to resist. That is futile.

Umesh Patil
San Jose, CA 95111
June 13, 2006.

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