Rajan cuts repo-rate...

Raghuram Rajan, our RBI Governor, keeps-up with his surprise element in the decision making process. Rajan said he is expecting inflation to remain benign, close to 5.8% in the September, even without the favourable base- year effect, lower than the target (6%) set by the government and the RBI... Nonetheless, the government’s commitment to stick to fiscal-deficit target would keep inflation low giving more room to easing... Low global commodity prices have given Rajan confidence of lower domestic and imported inflation... Lower crude-oil prices would keep the current account deficit in check by lowering demand for foreign-exchange and inflation... However, rate cut might increase depreciation and export-competitiveness in an adverse demand situation globally which the governor tried to supplement with increase in domestic demand when he cut-rates... Lower global and domestic demand has probably made Rajan to try to increase both... Interest- rate movements do affect exchange rates, too...  Exports have also tumbled recently... Lower growth projections in a subdued global scenario resulted in a near aggressive rate-cut by the RBI... Rajan has cut double than the expectations... According to the Taylor-Rule a 50 basis points cut in rate by the central-bank may increase growth by 1% which could improve ahead... INDIA is in a rate-cut cycle but that would continue to depend upon inflation... Rate-cut cycle ends when inflation starts growing more than wages, and, hurt demand and growth... If both inflation and wage increase equally then its effect on demand will be negligible... Growth depends upon demand and supply which are interdependent and should be incentivized to gain more growth with price-stability... Both, price-stability and full-employment is important for domestic- demand because price-stability affects the value of money and therefore demand, and, full-employment signifies that everybody is employed and has an income... Price-stability lowers demand for wages and interest-rates hike which also help to contain cost and price, and ultimately demand, domestic and external... Lower-prices are imminent for economic-expansion and growth; otherwise it will increase cost and price, and, hurt competitiveness... Lower interest-rate today could reduce prices by lowering capital-cost and increasing supply... 

Case for rate-cut, INDIA...

After delay in hike by the US’ Fed, analysts, now, are trying to figure-out what might happen to the Indian scene where inflation and inflationary expectations are on a downside with fiscal- rectitude commitment by the government because it directly increases demand in the market by increasing employment and wages/incomes and inflation under all supply-constraints, higher interest-rates too...

The government was responsible for too much demand creation in the economy... Public-spending mainly aims at the poor which increase their consumption who almost spend all of their wages which increases the value of multiplier... Public-spending on the poor directly adds to demand and therefore to inflation and higher interest-rate which crowds out private-investment... However, the crowd-in effect of infrastructure can not be ruled-out which also needs lower interest-rate so the government could borrow more and spend... Therefore, low interest-rate is a pre-requisite for more investment and supply... Lower interest-rate also reduces cost of investment and inflation, also by increasing the supply...

Nonetheless, monetary-policy manages supply and demand, and, inflation and unemployment by changing money-supply and interest-rate which depends upon inflationary expectations... Interest-rate depends on inflation and inflationary-expectations... In INDIA the RBI is also trying to mould these two by adopting inflation-targeting recommended by the Urjit Patel committee-report... The RBI has set an inflation glide-path to shape expectations about inflation and interest rate... The central-bank has committed itself to lower inflation... And, low interest-rate is also helpful in taming inflation because it would increase supply... Low cost of capital is positive for supply which is also important for low prices... Cost of capital and inflation might go down...

 It is still upto the Governor to decide for a rate-cut, since the monetary-policy-committee is yet to arrive which might strip the chief’s veto over the committee... The governor is still independent to deliver a rate-cut out of the policy date... However. September inflation data might be expected by the RBI on which the base-year-effect is yet to resolve...  Nonetheless, base year effects off will increase inflation which may deter RBI from cutting rates aggressively... Moreover low inflation is a sin-e-qua-non for low interest rates, RBI has cleared repeatedly...

We are in a rate-cut cycle because we are expecting prices to go down... Interest-rate is set according to inflation expectation, both long-run and short-run... Nevertheless, we are expecting lower inflation ahead therefore everybody is expecting a rate cut... And as the cost of investment will go down supply may improve...  

Wait till the potential-rate is achieved (US)...

There is still unanimity among the economists, even the Fed officials, about rate-hike possibility. Price-stability and full-employment are the two main objective of the monetary-policy and the underlying objective of the above two is economic-growth-(rate). The Fed’s point is that the present rate of growth shows that the economy is on a sustainable-path and the rate hike would showcase confidence in the present and future growth. But, that might diverge the economy to a lower growth-rate because demand and supply will go down due to increase in the borrowing-cost. Higher interest-rate, actually real-interest-rate because of low inflation, may result in higher savings and less spending. By increasing the borrowing-cost the Fed could create some inflation, but, again higher prices will result in lower demand. Low demand will further result in lower inflation and possibly deflation. Economists are arguing that inflation and inflationary expectations are biased lower so there is no need for a hike which could be right strategy under the present-case because demand is yet to pick because the country’s growth potential is above 5%. The Fed should wait the economy to get that pace. Why the Fed would like to hike rates when the economy is growing much below the long-run potential, inflation is too low and the external environment is deteriorating. The Fed might wait till the economy achieves price-stability, full-employment and full-growth... The first two have been achieved...

Rate-hike by the Fed may lower demand and increase deflation...

Low inflation means there is a deflationary bias in the economy which points to the lack of aggregate-demand and interest-hike may even lower demand more, and the economy could fall in a deflationary-trap. Higher and higher interest rate might lower and lower demand, more and more and prices will fall. But, if the Fed continues with its stance it would increase demand by lowering prices and increasing wages as we approach full-employment... Deflation is a problem when we fall in a downward-spiral and prices decrease at a fast speed and decreases supply. Moreover, we also know that deflation also increases demand by lowering prices which is likely to exceed supply and may increase prices in the future. Low and stable inflation as it is now and lower interest-rate when we are close to full-employment and higher wages will reinforce demand and growth... In this situation if the Fed wants to increase demand it can choose to increase nominal and real-wages by increasing the money-supply when inflation is too low... The level of interest-rate or real interest rate is determined by the inter-play of demand and supply for money... Lower interest rate may be a signal of low demand and also for high supply and both show that demand is low relative to supply; therefore it must increase by increasing money and wages... which seems to be a little dovish as compared to the Fed’s current stand, but it might be good for the economy in terms of demand and future inflation and growth...  

Deflation, Japan...

Japan has been facing deflation since a long time now even after with so much of fiscal and monetary easing... The policy makers think that inflation, as a sign of economic-activity, is must for increasing the growth rate of the economy... But, this is not happening... Inflation materializes when demand outpaces supply and then all the prices increase in the same direction... even the interest-rates and wages that decide demand and supply, and, inflation and unemployment in the economy... And deflation occurs when supply outstrip demand... Since Japan uses core-CPI as an index for inflation we need to view the problem from that standpoint... Generally, core-inflation is the inflation in the manufactured-goods-segment, excluding food and fuel... and CPI is the consumer-price or retail index and when we add them together it becomes core-CPI which is the retail-price of manufactured goods, excluding food and fuel... But Japan’s core-CPI excludes food and not fuel... It uses core-CPI with fuel... Prices, normally, increase when food and fuel prices go up, which are important for price-control, but Japan is a developed-economy and food-prices are generally not a problem therefore it uses core-CPI with fuel... Core-CPI shows inflation in manufactured-products which largely depends upon interest rate and wages costs... The reasons for low core-CPI is the low interest-rate in the economy for decades and is even after full-employment in the economy wages has been relatively stable even after increase in productivity... Therefore, when the cost of manufactured-products is not increasing, including fuel, then how inflation will ensue... The economy will face low inflation... When wages are not increasing how demand and inflation will go up... The economy has, actually cut down on nominal and real wages... Japan in an attempt to make its economy competitive for exports has even hit in its foot itself... Japan, like the US has kept wages low even after increase in productivity of the masses... Japanese core-CPI, including fuel, after consumption-tax shows lower inflation because of low demand which means Japan’s tendency to invoke core-CPI, including fuel, has not lost completely... If the Japanese economy tries to increase nominal and real-wages according to the productivity, it might be able to stoke core-CPI in the future...

China crash and INDIA...

Analysts used to say that market was bit expensive therefore the current crash might be an opportunity to invest more in equities. The market today in INDIA has shown a similar trend by recovering 400 points, the next-day of the crash. The rout in China might make INDIA a beneficiary in terms of receiving capital because it is the fastest growing economy with sound fiscal and monetary conditions. Capital flight from one country to the other also takes time. Capital will flow in. The same trend also supports the above point that INDIA will be at the capital receiving end. In the same line the expected delay in increase in US rates due to below target inflation and the slowdown in China will also save INDIA from capital flight. We might expect it to be the major recipient of capital of the current global slowdown US, Europe, Japan and now China. INDIA’s story is based on the domestic consumption, insulated from slowdown in exports; therefore we can expect it to be relatively stable.  The whole argument between Keynes and Pigou was about the self-correction feature of the market-mechanism. Keynes said deviation from full-employment might be corrected by government expenditure. However, Pigou said lower prices will help the economy achieve demand and full-employment, again. In China both monetary and fiscal policy is under the communist regime. Attempt to restore growth might work against the market-mechanism. More money and wage inflation may erode economy’s competitiveness... 

China for demand...

IMF is backing China for devaluing the yuan when it aspires to be a SDR currency. A currency the IMF and others will use to forward loans for countries in need. IMF is saying that devaluing yuan is a step in that direction. But, a reserve currency status is likely to increase yuan’s demand; therefore it should appreciate, and not depreciate. Dollar’s reserve currency status makes it strong. Actually, China wants to stop sagging growth rate by increasing export-competitiveness, but at the cost of domestic-demand by cutting real-wages with inflation. Does it sound good or any way better (?) when you are favouring foreign-demand against the domestic demand. This does not sound (too) good to go about it. In a way the Chinese are taking money from domestic-consumers and giving it to foreigners. The downward-nominal-rigidity makes wages hard to cut, but it is always easier to cut on real wages by increasing inflation in order to make the economy competitive. The economy is experiencing deflation which means low relative demand or high supply. To overcome this situation Chinese might try to increase demand by increasing real-wages by lowering the price-level which is also likely to increase export-competitiveness. Using lose money-supply in a low unemployment country, and higher wages and inflation will make you globally uncompetitive. Economists know that a reserve-currency status and strong yuan will depreciate dollar and help US’ exports...