Monday, October 24, 2011

Why interest rates will rise... And inflation too.

It's policy time again and as usual, speculation about the RBI's stance later today is more than rife. Some commentators feel that the RBI has hiked rates enough. Others feel that more hikes are warranted as inflation continues to remain at ridiculously high levels. Both sides, however, fail to provide for the anomalies of the Indian economy and suitability of traditional policy instruments to the task at hand.

Theoretically, when faced with high inflation, a central bank hikes interest rates which serves to reduce inflation in two ways. Firstly, higher interest rates suppress domestic demand which robs local businesses of pricing power. Reduced domestic demand also reduces the quantum of imports which results in improved balance of payments and currency appreciation. This, in turn, lowers the price of imported goods with it's consequent salutary impact on inflation.

Secondly, in an open economy, higher interest rates attract foreign capital which results in currency appreciation and hence, lower prices for imported goods which in turn serves to ease inflationary pressures. This impact, however, can manifest only when the country in question has an open capital account for debt flows.

When analyzing the applicability of these theoretical outcomes to India, one is immediately aware of a critical gap. India's capital account is completely open only for equity flows, not debt flows. As a result, higher interest rates are seldom accompanied by greater inflows of foreign capital. In fact, as higher interest rates squeeze domestic economic activity and corporate profitability, foreign equity flows reduce or even reverse. This worsens the balance of payments and can, and frequently does, result in currency depreciation at such times. As the currency depreciates, the prices of imported goods rise which adds to inflationary pressures rather than easing them. This makes it extremely likely that in India, with the existing framework, higher interest rates will cause higher inflation rather than combatting it.

Recent evidence supports this theory almost completely. For the second time in the last 4 years one can witness the currency collapsing and inflation increasing as interest rates rise. When inflation subsided somewhat in 2008/2009 as international commodity prices crashed it gave the RBI the unfortunate impression of a monetary policy success. With the RBI looking to replicate this 'success' once again, it is more than likely that interest rates will rise once again later today. And in the absence of a complete collapse in international commodity prices, so will inflation.

Thursday, April 7, 2011

An update and some links

Hey all,

Its been a hell of a long time since I last wrote and that’s probably because its been a while since I actually read real world economics and not a text book.  And while I was tempted to write about what I was learning, it always turned out too bookish to be a blog post. So many posts were started and abandoned, some forever, and some which I may revive when the opportunity presents itself.

As things stand at the moment, I may be in a position to get back to reading up on real world economics and once I am up to steam on what I have missed, writing again. It shouldn’t take too long; not much has changed except for my perception. So to ease into it, I’ll be sharing the most interesting facts and perspectives I come across for the next few days. So here goes,

A market for everything – Meteorite fragments for sale!!

An experiment in parking charges – on the right track, but will it work?

How the world’s economic centre of gravity is shifting.

$1,700: The annual benefit the average American derives from personal computers – Just a thought on pricing, though. It seems Apple would like to corner most of this benefit, which makes the net benefit to a Mac owner much lower than that of an average PC owner… Hmmm…

Don Boudreaux; Trade & Borders – Just one of his endless rants… My comment is numbered 14th…

Don Boudreaux: Costs are not benefits – Of course they aren’t! My comment is numbered 12th… and for a more well thought out point of view, read this (pdf)

And finally, via Greg Mankiw


Click on image to enlarge

Saturday, February 12, 2011

Rejoice for Egypt; Lament for India

So after 18 days of protest, Egypt is free from a dictator who ruled for 30 years. Its time for Egypt to rejoice, despite the uncertainty of how the Army will behave in coming days. But this event only makes the situation in India worthier of a lament.

The current Prime Minister is an honest man. But his incompetence in managing government becomes clearer with every passing day. From the Commonwealth Games, the Telecom Scam to S- bandwidth for ISRO, he has the singular honor of heading a government which has cheated the people of India out of more than the year's fiscal deficit.  An amount roughly 5,500 times that involved in the infamous Bofors scam which, unfortunately, we still find time to discuss. An amount which could retire close to 10% of the government's outstanding liabilities.

He also has the honor of presiding over the sharpest increase in basic food prices in more than a decade; an increase that drove millions back into poverty as they realized that feeding a family took far more than just honest hard work. 

Of course, it isn't the Prime Minister's fault. He's an honest man forced to make compromises in managing a coalition government. So the telecom scam satisfies the lust of one ally and food price increases purify the cancerous blood of another. And while they were at it, one needed to be fair to one's own party as well, which was served well by the Commonwealth Games and S-Band allocation.

Yet it is Egypt which has the opportunity to protest & overthrow an entrenched dictator and rejoice when the will of the people prevails. We have been taught to believe that our government is the will of the people. but is it, really? 

Do we really elect governments with a mandate to loot the nation? To enrich themselves while millions suffer.  Is this what democracy is supposed to be? Is this the will of our nation?