Tuesday, August 17, 2010

Have interest rates peaked?

So inflation is down to a single digit (barely) after a period of 6 months. Through this time, there has been a lot of discussion about monetary policy response to this phenomenon – one that seems to beset India every few years. And there will still be some hawks saying the RBI hasn’t done enough, but the fact remains, there wasn’t much the RBI could do in the situation. Inflation was, and still is, largely a supply side issue. And its retreat is a statistical event foretold by many, including me.

But its not as if lower inflation means lower prices. For the month of July 2010, prices have increased by 1.04% in absolute terms, an annualized increase of 12.41%. Inflation has decreased because prices had increased by 1.57% (annualized 18.89%) in July 2009. When Inflation for June 2010 was calculated it analyzed price changes in the period July 2009 – June 2010. This indicated an increase of 10.55%. When inflation for July 2010 is calculated, the relevant period is August 2009 – July 2010. Price changes in July 2009 were excluded from the period and those in July 2010 included. As mentioned earlier, since the rate of price increases was higher in July 2009 than experienced last month, the inflation rate reduced to 9.97%. This is normally termed the “base effect”.

But prices increasing at an annualized rate of 12.41% means that the possibility of inflation rearing up again is still high. Which brings us to the components of current inflation. Looking at last month, prices in the Primary Articles sub-group have increased by 1.85% (annualized 22.24%) and prices in the Fuel, Power, Light & Lubricant sub-group have increased by 3.21% (annualized 38.46%). For the last 12 months these increases are 14.94% and 14.29% respectively. Inflation in the Manufactured Products sub-group over the last one year is 6.15% and for last month, its negative 0.09%. And this would, beyond doubt, present the RBI with its latest challenge.

Falling prices are never good for economic growth. Monetary policy tries to control the rate of increase only and is seldom designed to achieve a decrease. When prices fall, consumption gets delayed, especially in durables, as consumers wait for prices to fall further. Coupled with high interest rates, deflation can stall an economy as consumers save to earn interest and benefit from price decreases. And while there are still some prices in this subgroup which have risen, this hasn’t been enough to stop the index from falling.

The possibility of inflation rising again always exists. But, the base effect in coming months is extremely sharp which reduces the probability significantly. If the index remains constant, meaning prices remain where they were at the end of July, inflation will drop sharply as seen in the table below.

Commodity Name July September November
ALL COMMODITIES 9.97% 8.20% 6.19%
I PRIMARY ARTICLE 14.94% 12.55% 7.63%
II FUEL POWER LIGHT & LUBRICANTS 14.29% 12.13% 11.87%

With Manufactured Products inflation at 6.15% and prices reducing, the situation has reversed. There is no justification for any more rate hikes. And if these prices continue falling, it would be time to cut rates before we know it.


  1. "Falling prices are never good for economic growth"
    "when prices fall, consumption gets delayed, especially in durables, as consumers wait for prices to fall further"

    not true at all.falling prices are the default behavior of an economy which is growing due to increases in productivity. prices of computers and phones and others keep falling and everyone including the sellers and consumers are better off .nobody delays purchasing a mobile today just because tomorow we'll have the same mobile cheaper. people have time preferences and they are different for everyone.an analysis of behavior cannot be done on aggregate .

    what you probably mean to intend is that in a debt based fiat system,inflation is the only sly but silent method of systematically making people that they have higher incomes .
    the best economic growth in the emerging market called as USA came from 1880sto 1914when prices fell by over 50-60% AND was accompanied by a 3-4% real growth.

  2. Yes, I am referring to the current currency system when I write about current events. What can I say - you keep me honest! Thanks for your comments. I really value them immensely.