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.
