Monday, June 15, 2015

Are central bankers fighting inflation or deflation?

Well, the answer depends on which country you are looking at.        

In India, Rajan has a clear mandate to control inflation to a target level of 4% (+/- 2% band). But if you look at US, Europe or Japan central bankers are struggling to bring back their economies from deflation mode to inflation.

It may sound strange for dummies to know few nations are fighting with inflation and others are staring at deflation at the same time. How can it happen? Here is my attempt to explain the matter. First let us understand inflation.

Is inflation good or bad?

Any price rise beyond tolerable levels hurts people. You would ask me to define tolerance level then. My answer is, if inflation rises beyond income or wage growth, it leaves less money at the hands of people. Let us assume incomes expand at 8% and the inflation is at 5%, you would still be left with surplus income and if the numbers are otherwise there is less disposable income. It becomes an indirect tax on the population.

One thing to note is wages too are components of inflation. When wages go up, inflation too would go up. If other components of inflation like the materials used, capital costs are not going up, inflation would not expand at the same pace of wage growth. Similarly productivity increase through improved skills in labor and better infrastructure will let the economy produce same or more with less number of employed labors. That would offset the effect of wage growth on inflation. So if we want to put it into a simplified mathematical equation, we can do like this:

Inflation growth = Wage/Income growth + Goods/Materials price growth (Agri, metals, all commodities) - Productivity improvements

What every country aspires is higher income growth at moderate inflation. But if we look at India, the price rise in imported goods like oil and gold were draining our incomes in the form of inflation at 8-10%. Now that gold prices are not rising and oil is at half price, we are seeing inflation being moderated to 5%.

Govt. and central bank’s actions can increase inflation

Inflation is dependent on international market forces (such as prices of imported goods, forex valuation etc.) as well as domestic policy stances by the local Govt. and the central bank. Many a times, it is the Govt.’s play a major role of inflation production factories. Here is how.

When we buy/sell a good or service for a price, it involves the exchange of money. Demand and supply of goods depends on market forces. But for the supply of money, there is only regulator – central bank deciding the things. If a central bank goes on printing new money beyond the economic growth demands it, there would surplus cash in the system. You have more cash to exchange for same amount of goods/services. Prices will go up though demand quantity for goods/services has not gone up.

For easier comparison, let us consider the land for which supply cannot go up. Compare the land prices to what it were 10 years ago and also take a look at the M3 money supply. You will notice that M3 money supply has gone up 5 times in the last 10 years. How many times the land prices have gone up in the same time? Does it look fair or not?

Chart for money M3 supply in India 2005 to 2015
Source: tradingeconomics.com

You would ask, why a central bank would print more money than needed? And no central bank in the world lends directly to the Govt. they are part of. Governments borrow money from banks by issuing bonds. Here is the catch. Banks can use those bonds as collateral to borrow from central bank which is RBI in India. If Govt. borrows heavily from banking system, it leaves less money with banks to lend to private. That leads to liquidity crunch. To avoid such a situation, central bank would print new money and put that money into supply through banks in exchange of the bonds issued by Govt. So coming to the next logical reasoning, a fiscally responsible Govt. would earn its income through taxes and other incomes. But a Govt. which spends more than it earns (fiscal deficit), sucks liquidity in the system. And if that borrowed money which comes at a cost is not put to productive use, it becomes a double edged sword. If some of the projects of the Govt. produce negative returns on the money spent who will pay for the losses and the interest which is due? Govt. will have to raise taxes or borrow more to repay. If the borrowed money (new printing) leads to wasteful expenditure, it destroys the value of money in the form of inflation. All the newly added money in the system did not produce any equivalent economic value-add so it results in inflation.

Fiscal Deficit numbers for India in the last 10 years
Source: tradingeconomics.com

What leads to economic recession or mild deflation?

We understand trade deficits, fiscal deficits leading to expansion of monetary base flares up inflation. But why the prices would remain same or go down and deflate? When the demand falls what else happens? Why the demand would fall? If there is unemployment and many do not have an income, how will they spend? Why there is unemployment? When big corporate make losses or are not earning profits, why will they hire?  

In the financial crisis of 2009, US went through a major setback as big corporate like Lehman Brothers went bankrupt and many big banks were in trouble as the derivatives they traded brought huge losses than they can normally digest. It burnt investors’ money and confidence. Losses in the banking system would mean there is less money in the system to lend for further economic growth. Reduced investor confidence would reduce new investments which results into higher unemployment in the country. That led to reduced consumer spending and took the economy through downward spiral of recession.

How the US central bank restored confidence?

Fed reduced the interest rates near to zero. So that corporate can borrow money to expand their business at negligible capital costs. It also ran quantitative easing (QE) program for years to buy bad debts in the banking system and replace it with liquidity and it also bought Treasury bonds issued by Govt. to infuse further liquidity in the banking system. This program expanded the balance sheet of Fed by trillions of dollars, most of it is electronic money and less printed currency in circulation. The losses in the banking system (bad debt in the form junk bonds) systematically got transferred to the Fed so that banks can resume operations normally. This along with lower interest rates helped US economy to come back to its knees and start hiring again. Unemployment rate have steadily came down (look at the chart) and its economy started showing revival. Though monetary base is expanded, inflation did not go up as that money did not end up as wasteful expenditure but it had increased the Govt.’s long term debt.

As the unemployment falls, wages will pick up as the competition in hiring heats up. That would increase inflation but Fed will raise rates in the same pace keeping the inflation in check. So for now, it appears Fed has successfully averted a recession.

Unemployment figures in the US
Source: tradingeconomics.com

Taking cues from Fed, European Central Bank (ECB) too has kept rates near to zero and has started a bond buying program to get out of the dangers of deflation.


Regression to Mean  

Inflation is cooling down in India and China but is seeing a tick-up in advanced countries. What we are seeing is ‘regression to mean’ effect. It appears like the dust of 2009 financial crisis has settled down. I hope in the coming years no war breaks out, a big natural calamity or unknown financial disaster strikes. In such a case, central banks around the world would run out of options to get their countries out of recession. But on the optimistic note, global economy is gaining momentum. Probably in few more months, all countries would be staring at inflation. That is the time you can buy Gold again.