Expectations and Consistency....

 

In INDIA it is a supply side driven inflation which might be stimulated by lowering the borrowing cost, it is not a demand induced inflation because employment has gone down... Not difficult to understand... 

 

It is true for the near term, nonetheless market rates are higher than the reporate and RBI policy is still accommodative... which could be lowered by using money injection and easing... More money supply by the OMOs and LTROs could help capitalise banks and improve credit creation... A quantitative easing could help increasing demand and supply and prices and growth expectations by lowering the market interest rates... 

 

The disconnect between the stock market and the real economy is obvious since the stockmarket has only the investment side based on expectations and spending, but the real economy has both the consumption and the investment side based on expectations and spending, the consumption side has been a laggard due to unemployment and lower investment and supply and higher inflation... 

 

INDIA is developing with mainly the consumption story and less savings and investment and higher interest rates and lower debt and demand due to higher inflation compared to the developed countries which needs (INDIA) more capital either from domestic sources or foreign... 

 

Lower consumption has resulted in lower investment in the real economy, but the stock market has no consumption side and domestic investors pour money on significant corrections and no restriction on foreign capital... 

 

The real economy has suffered due to lower consumption and investment and supply expectation and higher prices, but the stock market has soared on the back of lower prices and correction, but the prices in the real economy didn't correct much to increase demand and price expectations... Correction helped the stock market, but nothing such happened in the real economy... 

 

The inflation that followed the GFC was largely attributed to the too much loose fiscal policy and delayed roll back even when the economy recovered, all because of food inflation in cereals and the economy continued their exports which could be averted by better supply management of food, the economy didn't have the food security... Food inflation spoiled the party...

  

This time we must manage foodsupply wisely... Nonetheless, the commitment to roll back the stimulus could not increase spending due to the Ricardian Equivalence... People may think of stimulus as temporary and could not increase spending... We need consistency in the policy in order to stabilise inflation and unemployment and the economic growth.... 

 

Bond returns are calculated by using bond yields and bond prices which have a negative relationship, therefore lower yields mean higher bond prices and vice versa, which is used to contain the real value of returns overtime... Risk, holding period, inflation and inflation expectations also decide premium...Risk is often decided by a mismatch between shortrun and longrun assets and liabilities... Commercial Banks borrow short and lend long which could create liability problem coz investors could withdraw money due to uncertainty, though they may borrow long and lend short that could reduce the risk of default on liabilities...

  

Economic activity means spending which also depends upon (price) expectations about future, especially investment, profits are invested and wages are consumed... If people expect inflation they would increase spending, both consumption and investment, which further reinforces higher demand and prices and spending, economic agents are forward looking, higher interest rate would further increase the cost and prices... And, if they expect lower prices they reduce demand and spending, which would further lower prices, lower borrowing cost could further lower prices and increase supply.... if there is unemployment...

 

In the US we thought that there are no supply constraints and inflation could creep in only through full employment and higher demand of labour and wage price spiral, though imports could further lower prices, but in INDIA food inflation is the problem and less exports or more imports would help...

  

There are two main reasons for low inflation, one is lower real wages than productivity since 1970s that has resulted in lower demand and prices, and the other is lower oil prices, 11 of the previous recessions have coincided with oil price booms, which is now not a problem since the US is net exporter of oil... both have kept the inflation expectations low... If the policy makers target higher real wages that may still increase demand and price expectations... 

 

We have not seen inflation even after several rounds of quantitative easing in the US and zero nominal rates or negative real interest rates... The US has failed to increase demand, wages and prices, though the economy achieved close to full employment... The US economy tried hard to come out of the liquidity trap, but INDIA is not such trapped, nonetheless higher unemployment and lower borrowing cost could increase productivity, competitiveness and demand... Inflation could be expected if there is full employment and supply cannot be increased due to lockdown and uncertainty... Notwithstanding, demand is expected to go up after vaccine use and lockdown... Or proper treatment and recovery…

Prices, Expectations and Spending...

 When commercial banks are not passing previous repo rate cuts it means liquidity is less than adequate given the NPAs and loss to the credit creation power... INDIA market real rates are way above in the major economies which has also made the INDIAn business uncompetitive... The RBI must commit expansion till unemployment rate reaches the target 5% (the natural rate and the potential rate)... 

 

Unemployment management with the inflation target could bring consistency in the system... INDIA still needs to include low unemployment in its preamble... As long are there is unemployment in the economy there would be higher supply and low prices and higher demand and price expectations and spending... Moreover, there is also a natural real interest rate which neither inflates nor deflates the price level ie stable prices at full employment... 

 

The govt spending has had been limited in this unprecedented situation therefore the fiscal deficit is not the main concern... The RBI has still ammunition left, the market real interest rates are higher than the reporate it means liquidity has been less than required to facilitate transmission to lower market rates... More money-supply also means recapitalisation, CRR and SLR could be used besides LTRO to reduce market real interest rates... 

 

The govt must devote funds for the dams, reservoirs, irrigation and linking the rivers... Water harvesting could provide drinking water to scarcity areas ... Only 50% of the farms have irrigation facilities... Food inflation was behind the downfall of the UPA in the previous elections... Food has a higher weightage in the inflation basket which is a cost to the households, though lower prices increase real wages and demand and savings-investment and supply.... 

 

The commercial banks are marred with NPAs, in this the foreign capital could be used to increase investment by increasing FDI limit in the banks which could also lower competitive rates... Banks are holding the recovery in demand back which has also put investment and supply on hold... Rate cut would increase both demand and supply... when unemployment rate is more than normal... 

 

Elevated inflation means the RBI won’t cut in the near term which means demand pressure due to near term bottom-out (interest rate) and low supply could increase spending which may reinforce higher inflation... Higher demand due to accommodative stance would further boost demand and prices and expectations, lower supply due to higher price expectations would again push the price-level... Higher prices mean higher inflation expectations in the near term... 

 

If farm loans could be waived due to adverse conditions, business loans could also be raised or forgiven in this unprecedented situation of corona pandemic... This could provide much needed breather to the stricken business activity due to loss in employment and demand... Business loan waiver could help increase employment, investment, demand and supply and the economic growth, it would increase the ability for business expansion... One time bailout would help the recovery... 

 

Expectations are self reinforcing, if people expect lower prices they delay demand and spending, which further lower prices, moreover supply would increase, again which would lower the prices and , if they expect higher prices they hold supply, which further increase the prices and would increase demand and price... 

 

Nonetheless, any intervention to increase/decrease money supply would again reinforce the prices (too)... If there is unemployment and disinflation or deflation, more money supply would further lower prices by increasing supply and demand and if there is unemployment and inflation less money supply would further lower supply and increase prices and lower demand...