A marked change of the past one decade in the economic theories has been the slow recognition to the supply side economics, which had taken a back seat in the debate circles and the demand side took the lead in the policy making, both at the Govt and the central bank level.
This has happened in the light of the evidence that the developed economies experienced slow or lower growth in the price level or inflation against the quantity theory of money, that higher money supply lowered interest rate and borrowing cost and higher supply resulted in lower price level and inflation.
In the long run, the supply side has improved a lot and kept prices low, which also increased savings reinforcing lower interest rate and prices that kept inflation and expectations under control until the pandemic hit in 2019 which severely affected the supply side and inflation and expectations spun out of control.
Inflation expectations affect spending today, that is why the Fed tried to increase inflation expectations since the crash of 2008, but it did not happen, prices remained muted and the inflation was behind the target because investors and people experienced and expected inflation to remain low.
Though, the scene has changed dramatically on the eve of the covid-19 when lockdowns hit the supply side and the economic activity around the world was deeply disrupted and lowered employment, too.
Lower economic activity resulted in lower demand which sent the commodity prices into a tailspin, but since then demand has bounced back quickly than supply which has now sent the commodity prices re-inflating.
When prices increase they themselves restrict demand, there is no need for the central bank to increase borrowing cost to lower supply and demand which could further reinforce higher prices, it probably helps stabilise the situation and vice versa.
Otherthings remaining constant, an increase in the prices would control demand and increase supply and if the central bank increases interest rate it would reinforce higher prices and demand and supply would go down more than before at a quick pace and vice versa.
Higher price expectations could increase spending today which could further reinforce higher prices and spending... Significant higher prices would reduce demand and increase supply... Little higher prices and expectations are good for investment and consumption too...
Fed's objective is neither inflation nor deflation, but stable inflation and expectations to ingress spending and growth... Higher interest rate are good for savings, people must welcome the move, investors too...
Stagflation is high inflation-high unemployment, but this time we have high inflation-low unemployment, we are in a more comfortable zone as far as unemployment is concerned... The economy is in good shape...
An important part of the Monetary Policy is the neutral stance or stabilising inflation and interest rate expectations which the commentary misses... Analysts either talk about rate cuts or hikes, about extremes, but miss neutralising or stabilising inflation, interest rate, prices and growth and expectations...
The Fed has said that it is targeting the neutral rate at which inflation and expectations are stable, though if the Fed hikes or cut that might reinforce prices... Rate hikes could reduce supply and reinforce higher prices and rate cuts would reinforce higher supply and lower prices which could increase volatility...
If the Fed tries to carve out expectations investors would try to speculate to gain by being preemptive which could be self fulfilling... Though, a stable or neutral interest rate might make the investors conscious of speculating and expecting too much or reading too much the Fed's words and try to gain from it in the short run and invest in a stable manner...
Foreign exchange inflows depend upon inflation and expectations, too... It is good that the RBI has sufficient reserves, but oil and imported inflation could increase depreciation and could increase outflows... The RBI must target an exchange rate that is conducive to lower imported inflation...
