Hints at rate hikes would fail inflation targeting...

The data on important indicators for the US economy show improvement in July compared to the second half of June. The economy is doing fine one month and the trend also reverses every one month which may mean that interest rate hike decisions is affecting the spending decisions, to say whenever the economy shows signs of improvement and the Fed comes close to a rate hike spending goes down and when it delays the indices improve again. Expectations about interest rate hike are important for the outcome because whenever people expect higher real interest rate, since inflation is low a nominal increase in the rates would increase real interest rate and savings, and lower spending would lower the price-level, but the Fed has committed higher inflation and a higher real interest rate would lower spending and the prices, opposite of the Fed’s policy. The Fed is trying to catch a train before the time by increasing the interest rates which would again work to lower inflation in the future too. A higher interest rate means lower demand and prices. Communicating the direction of the economic-policy is important to make people conscious about the change which makes them to act rationally. How can people expect inflation when the monetary policy is working to curb it before time by increasing savings and lowering spending? The signals are misleading. Nonetheless, if the Fed communicates that it would keep the interest-rates unchanged till inflation leads to wage demand hike after full-employment, it may increase spending and economic-growth because inflation is still half the target and is also expected to remain low due to benign global commodity prices. Brexit would further lower global demand, trade and investment and prices. The Fed is trying to find the full-employment level which it thinks it is closer but wages hike demand is yet to become visible to prove that we have reached full-employment, but low inflation is also responsible for weak wage demand. To increase wage demand and spending and growth the Fed may choose to remain accommodative till the economy actually starts overheating. The fear that the Fed may miss rate hikes at the right time is overdone because the economy is getting updated data every month and the reaction time would be much less, so to think that we are behind the curve is useless and not true. If the Fed waits for inflation and rate-hike that would do well to communicate clear that inflation would signal a rate hike and a lower inflation means delay in the rate hikes which might increase spending, both consumption and investment, by dis-incentivizing savings through low interest rates. The Fed manages interest rate by controlling money-supply which increase/decrease demand and supply and decide the level of inflation/disinflation/deflation, but from a policy perspective lower prices are more viable because they increases real wages and real exchange rate which increase domestic demand and also the demand for exports. Low prices, higher savings and low interest rate might be good for investment and supply, and, higher real wages and real exchange could be good for demand, consumption and exports. The Fed’s policy to control inflation before time signals controlled prices, not inflation. It is working against its own inflation targeting, by hints of rate hikes…

The Fed, in nostalgia...

Inflation and/or deflation affect the value of money and therefore demand and supply in the economy by the way of increasing or decreasing real wages and/or real interest rate, both as a tool to achieve full-employment. Inflation reduces the real interest rate which pushes investment by lowering the value of money and debt, and also reduces the real wages and demand which decreases the cost of labor and capital and increase investment; however disinflation or deflation increases the real interest rate and real wages which increases the cost of investment by increasing the value of money which might not be true. Inflation is often used to induce investment and supply by increasing the price-level, and disinflation or deflation increase demand and investment by decreasing the prices. Of the two, it is clear from the above lines, that inflation reduces demand,  and disinflation or deflation increases demand, and, investment and supply, both, by reducing prices and increasing the value of money and, real interest rate and real wages. Therefore, we might also get closer to the point that during a slowdown i.e. in a period of high unemployment and low demand, an increase in real interest rate and real wages by lowering prices or inflation would incentivize demand and investment and supply when the money-supply is loose. Nonetheless, inflation and slowdown is hard to happen at the same time because during slowdown there is a pressure on the price-level to go down in the presence of higher unemployment. Nevertheless, inflation coincides with boom and low unemployment. Thus, it is futile to expect inflation during low growth and higher unemployment. Then, it is not worth to expect that inflation would cut real interest and real wages to promote supply and investment, but lower prices and more money-supply is expected to increase real wages and real interest rate which would also increase savings and investment by increasing the value of money. A recent study shows that prices significantly affect the economic growth rate and the relationship between the two is negative, i.e. lower prices increase economic growth. Among the major factors affecting prices and economic growth are money-supply, current account deficit and house-price-index. Therefore, the Fed’s targeting of higher income, demand and inflation failed to increase real wage expectations and spending, and lower real interest rate never happened during the slowdown. Notwithstanding if the Fed had committed higher real wage expectations it would have increased spending, and, savings and investment too by increasing the real interest by committing a lower price-level.    

Food inflation is holding us back...

The food-inflation that is rampant in the Indian-economy could be primarily ascribed to the low level of technology, investment and over-dependence on rains for irrigation have made the RBI delay rate cuts in the expectation of a good monsoon and lower prices of food. However, INDIA is also a big exporter of cereals (rice and wheat), in which inflation is close to 6.3% and had been higher in the previous years, could be brought down to a lower level if we try to reduce exports and increase domestic-supply to lower inflation. The men in authority argue that they cannot increase domestic-supply by restricting exports because it would lower domestic-prices of cereals and would hurt farmers. Nonetheless, everybody, the government and the RBI, still expect that a better monsoon would help bring down the inflation in cereals, therefore if we increase domestic-supply by curbing exports it would have the same outcome, lower prices. INDIA could easily lower some of its inflation by curbing export of cereals. Food-inflation has kept the RBI in the delay mode in the expectation that time may itself improve the supply-side without lower interest-rate, however the government has committed interest-rate subvention which might not work with credit-facilities-gap in the village areas where most of the farmers are forced to borrow at very high rates form traditional money-lenders. Agriculture has now become a high cost and risk sector of the economy because of high rural credit cost and hole in irrigation facilities. Lack of the irrigation facilities and agricultural loans have been the main culprits for farmer’s suicide. The policy setters must try to eliminate these repercussions which would also reduce inflation and interest rate and propel economic-growth. Prosperity of agriculture, lower food inflation and lower interest-rates are sine-qua-non for a healthy-high economic growth. Nevertheless, allowing 100% FDI in food retail and processing was a major supply-side reform of this year’s budget which might again help reduce food-inflation and increase farmer’s income by improving the supply chain and storage and by reducing the middle man chain in the agriculture. The government has pledged to increase farmer’s income in five years which would affect demand and growth positively. The government’s vision of the rural and agricultural economy would take time to materialize to bring out their best, but, implementation is the key and the sooner it is, the better it is.           

Inflation reduces the value of capital...

Although the Indian-economy is growing fastest among the major world economies, its current growth rate is lower than its peak performance after the global financial crisis of 2008 when the economy received fiscal and monetary policy stimuli by the policy-makers which kicked-off the growth-rate in the following years. However, the inflation–rate also soared to double-digits which the central banks tamed by tightening money-supply and increasing interest rate and the government also curbed its expenditure in the wake. Nonetheless, the previous UPA government continued the stimulus longer that pushed inflation to intolerable heights when INDIA is still a developing economy with various types of constraints over investment and supply. The last decade of the country’s growth path shows that the economy is responsive to increase in money-supply, either by monetary-policy or fiscal policy, but in a supply-constrained scenario the economy easily starts overheating or inflating.

Inflation is an important determinant of investment and growth. The foreign investors deter investment when they experience and/or expect inflation and depreciation. Then the question arises that “how, then, inflation be good for domestic-investors or investment?” Inflation more than increase in wages or income reduces real wages and demand, and hurts growth. Some economists also argue that inflation reduces the value of debt even when the nominal interest-rates go up and you pay more in money terms. Inflation reduces the value of money thereby reducing demand for other things and increasing demand for money wages that makes the economy uncompetitive. Higher-prices also reduce domestic-demand by increasing nominal-interest-rates and reduce real-interest-rate which also reduces savings which could further be translated into higher interest-rate and low investment, inflation is a signal. The rate of inflation discourages investment, demand and economic growth.

Inflation reduces the value of capital which means less investment.  

Lower interest-rate might be correlated to higher supply and lower prices...

The scarcity of capital depends upon the scarcity of investment goods and services, and, consumption goods and services since a rise in the price-level would prompt the central bank to increase interest-rate and reduce demand, consumption and investment, in order to reduce fall in the value of money and demand when supply cannot be increased in the short-run. The central bank tries to control demand in case of lower supply to keep prices in check. However, if we have space for increasing supply then the central-banks may reduce the interest-rate to improve supply and control the price-level or inflation. Therefore, the first task before a central banks is to determine whether the inflation is supply-side induced or the demand-side because a supply-side solution in case of higher demand and inflation seems more feasible than to control inflation by reducing demand which diverts the economy from a higher growth trajectory. A lower interest-rate regime may also increase supply and lower prices depending upon the actual availability of goods and services in the economy. Therefore, the central-banks must try to control demand when there is no scope of increasing supply of goods and services. Nevertheless, lower interest-rate might be good for the supply-side (investment) and the demand (consumption) side too. Therefore, if lower interest-rate increases supply or productivity to lower inflation instead of just demand and inflation it should be welcomed. Conventionally, higher money-supply and lower interest-rate is supposed to stoke demand and inflation in the event of supply shortage, but, how the central banks can ignore that the same interest-rate which controls demand is also responsible for increasing the supply because lower capital cost might be significant for it. Keynes said that capital is not that scarce as compared to other factors of production since the central banks could resort to printing money when there is a need and its real scarcity depends on the real availability of investment and consumption goods and services in the economy. The capital is scarce because other things are scarce. In a big economy like INDIA how inflation is explained with so much of unutilized resources and excess capacity, its inflation might be attributed to low investment and supply compared to high demand which could be incentivized through lower interest- rate. The central banks try to contain demand and inflation in the short-run when the long-run objective is to keep prices low by lowering the cost of credit and increase supply. Increasing interest-rate and reduce demand and inflation in the short-run is a short term strategy, however improving the supply-side and demand too by lowering the interest-rates might increase inflation in the short-run but would also increase supply. The interest-rate in the developed world has shown a downward bias in the long-run and it is an assumption that interest-rate in the developing and the developed world would converge in the same direction in the long-run. In many of the developed countries with low population growth rates the interest-rates have remained around zero in the past several years with deflation. Japan is now a classic example of economies with zero-lower-bound or liquidity-tarp and deflation for the past two decades. In the developed world the improvement in the supply-side due to lower interest-rate has made the price-level less volatile and less volatility has also kept the interest- rate low. The example of the developed countries shows that in the long-run supply-side has improved much to keep the prices stable when interest-rates are at rock-bottom.