(Deflation)... They never let it materialize...

Higher real-rates or lower prices or deflation makes money more valuable in terms of banks deposits and bonds owing zero nominal interest rates. Money becomes more valuable. But, some economists say that lower-price expectations make people delay spending. I think lower prices increase the value of money therefore people accumulate reserves not because they expect lower prices ahead especially in the liquidity-trap. People always think that prices would go up and they need to save more for the future. Banks also keep the long-rates higher than the short-run rates which also depend upon expectations of inflation besides just inflation. The central-banks conduct monetary easing to lower long-term rates first and then it lowers short term rates. Banks have kept long-term real interest rates higher than the short-term rates. Since zero-lower bound, nominal rates are zero we also do need to lower long term interest rates which also depend upon inflation/deflation expectations. Lower price expectation would lower long-run interest rates and inflation would increase the long-run interest-rates. Expectations depend upon right information and more on economic policy.

Keynes is right upto the zero lower bound or liquidity-trap for which he advocates fiscal policy because interest-rates are zero. Fisher talked about real interest rate i.e. inflation adjusted rates and Wicksell natural or equilibrium interest-rates at which there is neither inflation nor deflation which means constant real interest rate. The economists still say that there is no unique set of nominal and real interest rates which might be true. Non-economists people rarely think about real interest rate... they are occupied with nominal interest rate. The Fed says it is Wicksellian economy...

Japan might also target real wages to increase demand and supply and inflation by increasing consumption, and when demand goes up supply is increased to earn profits by investing more at lower prices. The forecast about the real GDP growth may influence investment decisions... Lower price increase demand and supply and consumption and investment... In the stocks lower prices are an opportunity to buy at low and sell at high... Lower inflation might lower cost and increase profits... Labour demand less wages and interest rate/cost also goes down in a low price regime... Lower prices too reduce inflation expectations and may increase spending... Lower prices help demand...

Most of the economists argue that deflation is unending and unlasting which might be wrong, because when prices fall too much demand increases and supply also goes down which may push the price-level up in the future... People know that supply is limited so they must spend now... Moreover, if they expect lower -prices they would also save less which again increase spending... Deflation might not last too long, but may help increase real-wages and demand and inflation in the time ahead, if other things are constant...

They never let it materialize... Japan always used policies to increase inflation and inflationary expectations through loose money-supply and communication... They never accepted deflation as a tool to increase demand; real-wages has been low... Although the economy is near full-employment, but lower rate of population growth is also responsible for low demand and inflation... Nevertheless, Core-inflation has shown improvement (more inflation)... Improvement in wages in yen-terms is very slow or low compared to the size of the money-economy in the yen terms... It would need a very-very big stimulus to reach the threshold that could increase wages and spending... Japan could communicate deflation and increase money-supply in order to increase real-wages and demand... Probably, 10% of the money-base...

Neutral or Natural real-interest-rate...

Janet Yellen, at the Fed, in Jackson Hole on Friday expressed her views on the US economy that the sustained improvement in the labor market and growth rate warrants a slow hike in the interest-rate if the incoming data is consistent with the targets set by the bank. The Fed has constantly said that Core-CPE (Consumer-Price-Expenditure) at 1.5% is near the inflation target which is in line with the unemployment rate close to 4.9 % although the growth rate is tepid. However, it is yet unclear that the bank has shifted its official inflation index the CPE  to the Core-CPE which might show the increase in the price-level due to full-employment and wage-hike since inflation from other sources like transport or oil and food show no price-pressures and loss in the domestic value or purchasing power of the dollar. Currency debasing is debated widely in the Political-circles. The Fed’s Fund-rate path demonstrates that it would be near 2-2.5% by 2018 and if we assume the same inflation target we arrive at a real interest rate of 0.25% which means that the real-interest-rate would increase and not fall compared to the present condition when nominal Fed’s fund rate is 0.25-0.5% and inflation is 1.5%, therefore, the real-rate would be 0.5% - 1.5% equals -1% lower than the real rate in 2018. Hence, 3 years down the line we could expect real rates to be higher than today at which the investment-spending would decrease and not escalate and inflation would go down because real rates would be higher than the natural-rate today when spending is low. The current scene explains lower natural real rates when inflation is low and stable little above zero at 1% which might need slight tightening to bring complete price-stability by increasing real-rates and nominal interest rate. Nonetheless, lowering demand to lower the price-level is different from increasing supply and lower the price-level because the former lowers employment and demand, whereas the supply increases employment and vice-versa and lower the price-level. Therefore, the Fed is expected to find or achieve the natural real interest-rate by keeping money-supply loose, and increase supply and lower the price-level than by keeping demand and the price-level low by increasing the real-rates and unemployment.         

Synthesize...

In the context of the 2008 Financial-Crisis in the US economy that send jitters to the rest of the global economies, the long divide between the “freshwater” and “saltwater” economists also known as “the neo-Classicals” and “the neo-Keynesians”, respectively, over the rigidity or sticky or no-rigidity of the key economic-variables, could be brought to the light of evidences to understand the view-point of the two schools of thought. The neo-Classicals maintain that the economy in the long-run could self-equilibrate with the help of change in the real economic variables like, real-wages, real-interest rate and real exchange rate, i.e. inflation adjusted variables, while the neo-Keynesians believe in government intervention and sticky or rigid prices to converge the economy to stability. In the earnest efforts to tackle the recession that followed the Lehman-brothers, an investment bank, collapse the Federal Reserve Bank of the US embarked on massive monetary-easing and set inflation target to achieve economic-activity, full-employment and growth-rate. Nevertheless, the economy after these seven–years showed recovery in terms of employment and economic growth, but inflation remained below the target. Even after so much of easing the economy failed to increase demand and inflation and the discussion is still on to raise the inflation target, but as we know inflation is also a kind of tax and it reduces demand and growth by increasing the price-level and the interest rate. Thus, inflation reduces demand. The Fed initially thought that more money-supply would increase inflation and inflation expectation, but this did not happen as oil-prices, that have constrained the growth many times, have gone down due to innovation in crude oil by shale. “Targeting” and “expectations” have been the buzzwords in Economics, now the countries target economic variables like prices or inflation, wages, interest-rate, exchange rate and economic-growth, and also try to shape expectations about the future- values of economic variables. There has been a tradition among the major economies to target higher GDP projections to increase investment. Nonetheless, inflation targeting and exchange rate targeting are also not uncommon. However, the question is still there that which variables to target, nominal or real and if there is a need for government-intervention (?). The neo-Classicals favor the real economic-variables, but not government-intervention; however, it is still unclear that the central-bank is a part of the government although independent. Keynes’ prescribed fiscal-policy in the liquidity-trap to increase nominal-wages and effective-demand whereas Pigou recommended to increase real-wages and, probably, the same effective-demand. Notwithstanding, if we target real variables with the help of monetary and fiscal policy we might get results or outcomes soon. We might try to affect real-variables since nominal variables confuse the agents. For example, the Fed has committed inflation and also income which might send contradictory signals about real wages and real-wages expectation which reflect the real position. In this situation spending would be low and people would also save more due to higher inflation expectation which during recessions may negatively affect demand/supply and economic-growth. Conversely, if people see and expect lower prices they would increase spending because real-wages and real-wage-expectations would go-up. Similarly, if the Capitalist see and expect lower prices of investment goods and services, they would increase investment because real cost would go down and real profits could increase. Moreover, if foreign importers see and expect lower domestic prices they would import more because real exchange rate would increase, exports would increase. All the three cases above might help increase demand/supply, employment and the economic-growth, but with the help of low inflation and inflationary-expectations and real economic-variables. However, the Fed is trying to the same with the help of higher inflation and inflation expectations and nominal variables which have given only limited results and sub-par growth rate. The US has had been the home of many great economists of which Milton Friedman is outstanding and widely celebrated. He himself proposed “the optimal-monetary-policy” that says that monetary-policy might give better outcomes in terms of demand/supply, employment and economic growth if the nominal interest rate is set substantially low and there is little deflationary bias  in the economy (Aubhik Khan, Robert G. King & Alexander L. Wolman, 2002). Moreover, the relationship between deflation and depression is weak and there are periods of satisfactory growth and deflation in the history (Andrew Atkeson, Patrick J. Kehoe, 2004). The Fed is indirectly targeting nominal wages, interest-rate and exchange rate through inflation which misses the outcome of more demand/supply, employment and growth-rate, but if the Fed targets real wages, real-interest-rate and real exchange rate by lowering inflation and inflationary expectations or through little deflation it might be able to achieve better outcomes, demand and growth. There has been a real-wage and productivity gap in the US since 1970’s which the Fed and the government might try to level in order to increase domestic demand and growth (Mark Setterfield, 2010). Committing a lower inflation or little deflation path by the monetary-policy might help increase real wages and domestic demand. Likewise it would also increase real-return on investment and wealth thereby increasing supply and growth (Jonas Crews, Kevin L. Kliesen and Christopher J. Waller, 2016), and, is also likely to increase real-exchange-rate (real-exchange-rate equals nominal-exchange rate multiplied by the foreign country price-level divided by the domestic price-level) and exports, and growth. Friedman has clearly acknowledged that the optimal-monetary-policy would entail dis-inflation or little deflation and would require a sufficiently low nominal interest-rate. In the developed-world the evidences show that price-levels in these countries have gone down even with huge increases in the money-supply and lower interest-rates in the long-run. In the long-run, perhaps lower borrowing cost has helped improve supply and lower the price-level. The Fed may review Friedman’s optimal-monetary-policy in respect to the relationship between lose money-supply, lower borrowing cost, more supply, lower price-level or inflation and real-variables – real-wages, real-interest-rate and real-exchange-rate - for better guidance about the future monetary-policy.  

Food is hot...

The inflation reading for July (the latest) show breaching of the inflation target for this year and risks even the next year’s target, has made the RBI and the Government shift the goalpost to the next few years, instead of 2018. Now, the inflation target for the coming five-years is 4% with a band of +/- 2% given the high food-inflation experienced almost every year. The prices of one or more basic food items catch fire each year. Food and fuel are important from the point of view of inflation and volatility, and have a higher weightage in the inflation index. However, low fuel cost in the near past made the inflation target achievable even when food inflation remained high and the government imported pulses on a large scale to cool-down its domestic prices. The two successive droughts in the past years have worsened the food inflation and lowered the rural demand and growth. At one place income has come down and at other higher inflation has gone up which have kept real incomes lower in the rural areas when the economy is still recovering from a downturn. Inflation too is responsible for lower demand and growth because it reduces demand for other G&S.  Nonetheless, hope of a good monsoon and lower food inflation comfort the economy in terms of lower expected inflation and interest rates on the account of the credibility established by the RBI to check inflation and inflationary expectations in the past. The RBI sacrificed growth to contain inflation and has now an inflation target out of which it is expected to tighten and below which it would lower interest rates. Like rate-cuts, rate-hikes could also be delayed in expectation of lower prices adjustments. The central banks indirectly manipulate interest rates through money-supply and the RBI has committed a liquidity-neutral stance which also means the natural-rate at which there is neither inflation nor deflation, if there would be surplus liquidity there would be inflation or when there is a deficit there would be deflation. INDIA is yet to achieve that rate, but food inflation is a volatile category which requires more supply and that is determined by a number of variables other than interest rates like weather, trade-restrictions and farmer’s welfare. Deflation should be considered different from disinflation. Opposite of the developed-world in deflationary pressure, INDIA is going through disinflation. Deflation occurs when the price-level go below the base year. However, when there is scope for imports to cool down domestic inflation and lower interest-rate, the government could bring out tenders and might provide interest-rate subvention which would help bring the overall inflation and interest-rate down…   

Inflation-targeting in the US...

The Fed could raise inflation either by increasing demand, higher demand would increase the price-level, or reduce supply, lower supply would increase prices, relative to each other. Demand-side would work when employment and real wages would go up and supply-side would work for inflation targeting if supply goes down. Both, together, mean that demand should go up in comparison to supply, i.e., demand should go up relative to supply or supply should go down. Moreover, low prices and expectations show that supply is abundant and demand is low. In this situation inflation targeting would lower real wages and demand, supply would outpace demand, prices further would go down. On the opposite, if we lower inflation expectation, lose money-supply would also increase real wage expectations which means more spending and less wage demand due to lower prices could also increase export competitiveness. If prices would fall it would do the both increase demand and also reduce some supply due to lower prices which might help the inflation targeting. However, if the Fed tries to increase inflation by inflation targeting it would reduce real wages expectations and demand and spending and higher prices would further improve supply in the event of low demand and lower prices could fail inflation targeting. Higher inflation expectations would not let inflation targeting work because demand would go down and supply would increase means lower prices, however lower inflation expectations might increase inflation in the future by increasing real wages demand and limiting supply due to low prices...

Stressed assets, miles to go...

The Indian-economy is doing well when we see growth in terms of the unemployment rate (4.9%) which is the reason for an overheating economy because low labour supply has made wages rise in a consistent way with the rate of growth i.e. growth has increased demand but strings on investment including slow interest rate cuts by the RBI has made the cycle somewhat downbeat and slow in terms of investment and expenditure by the public-sector is seen as a tool to crowd in private investment. The stress on the commercial banks’ balance sheets due to stressed assets is another factor that has contributed to only half of the interest rate transmission in the market rates. However, the RBI is now using MCLR in deciding the lending rates and expanding the bank licenses to increase competition, but the stress on the banking is now a wholesome around several Lakh Crore Rupees of which the government would be able to contribute in Thounsand Crores this year. The loss of banking is a debt gone bad after a boom and is restraining the profitability of the banks by constraining lending during low growth. Liquidity in the domestic economy has also constrained the interest rate transmission because of bad loans and fewer funds for credit creation. Nonetheless our RBI governor has made standout that the RBI wants a liquidity neutral position and has done liquidity improvement through OMOs and other levers. The government and the RBI might try to incentivize the sectors that contribute to low prices and wage demand because that would increase cost and reduce investment by delaying rate cuts and loose competitiveness. But to increase domestic demand the policy makers may try to increase real wages and income to increase demand and growth by reducing the price level by more investment and supply in the economy by improving liquidity. More liquidity in the economy would make the commercial banks lend in large scale by lowering the lending rates. Keynes said that nominal wages and prices are sticky at low levels, but lower price rigidity is not supported by the evidences. In the Western World increased liquidity and lower interest rates have improved the supply and reduced the price-level in the long-run. Lower price expectation and increased real wage and income expectations could increase spending, consumption and investment, both. And, GROWTH…  This is our Governor’s last policy during this term but we still expect that the RBI could increase liquidity and increase interest rate cut transmissions when the public sector banks are constrained of capital.