Is RBI handling inflation correctly? Part 2

In part 1, we saw the overheating phenomenon in India and why RBI is pushed into action. In short, consumer inflation is just part of the story, most important danger lies in the asset price appreciation that pushed RBI to take hard steps. So, what is inflation? In this part we will see how the central bank controls the two main entities - interest rates and exchange rates that affect inflation. This part will be more about inflation theory about the two main tools of a central bank.

Inflation is the classic condition of more money chasing few goods, and it means that the value for the currency you hold is having less value than what it used to be. There are four main components - domestic production, exchange rates, interest rates and consumption rate. Here interest rates (atleast short term) are more of an independent variable controlled by the central banks, domestic production depends on this and entrepreneurial skills + healthy conditions, exchange rate is semi independent in some countries controlled by government while it has to be really proportional to domestic production and consumption rate is dependent on people's psychology and all other variables. Together the effects end up at the consumer when he sees the high price and calls that inflation. Actually, it is just an end product of a whole deal of complex dependent and independent variables. Let us briefly look at each of them.

Interest Rate:

Interest rate is fairly direct. I giveup today's thing to you in anticipation that you will give me something better tomorrow. So, I pay you $10 today and expect you give me $11 back after a year. Here I have $10 available readily, and the other guy has expectation of making atleast $1 in the year's time. The $10 ready availability is called liquidity and the $1+ that he could make with this is called productivity. Now, if the system is perfectly elastic, and I now have $20 still I can loan it to him fully and get $2 back and so on, indefinitely. But, real systems are seldom elastic. At somepoint, the other guy cannot take all my money and still make enough money to give me the interest. At the that point the interest rate starts climbing down. Thus, in global bond markets (that is essentially a market for trading loans) as liquidity increases interest decreases. Conversely, if there is a credit crunch where I dont have $10 even and none of the people have it then the interest rates increase. But, there is a limit here, at some point the producer cannot give enough interest to you without raising prices so much or go out of business.

In the first case, when there is excess liquidy, the money fetches lesser interest rates in the long term, and this makes somepeople to not giveup today's comforts or they go for other sources of making money. Henc, they buy up junk instead of loaning the money and this causes inflation and asset boom. In the second case, the increase in interest rates causes the end products to be costlier and drives up the interest. Thus, inflation can be a resultant of both over liquidity and under liquidity - Damned if you do. Damned if you dont! This is where the central banks enter the system. They first establish some mechanism in which the markets are dependent on them and keep this as an handle. For example, they always give banks the short-term loans (they can print money at will and destroy it when they get back) and mandate the banks to keep some of their long term loans with them and this is the great way in which hold control. And even more, since they are the most trustable business system (they print currencies) they can setup some rate for taking medium term loans from other people (these are called treasury notes or bonds or T-bills) and many people keep atleast some portion of assets in these instruments as they are the safest.

So, now they have a full handle on the system. On one end they can get money from people at pretty low interest rate and on the other end they can loan short term money to banks at any rate they choose, as they print money. So, if the liquidity goes beyond a certain limit, they start issueing more higher rate treasury notes and increase short term interest rates so that people will put more money into governments and take less money from them. Thus, contrary to what we expect, liquidity forces T-bill interest rates to go up, while the rest of the interest in other long-term instruments that offer at more interest rates might fall if they dont find enough takers. This is what currently happening in the US. Long term bond rates have fallen and short-term T-bills have increased for a while now. At some point, the yield curve will be inverted, short-term loans fetching more interest rates than long-term loans.

Now, what if there are enough takers for the loans. Then, both T-bills and long-term rates go up, and this is essentially not an over liquidity situation but actually a liquidity cruch (more demand than supply of money). This is what happening in India. Whether RBI had increased rates or not, the banks would have increased the rates, as there were more demand for loans than more supply of deposits. This is actually a healthy condition IF the loans were absorbed by the producers implying we are having rising productivity. But, most of the loans were absorbed by stupid consumers who bought houses and depreciating assets out of them, thereby not causing any increase in productivity. With the natural increase in rates these people will be priced out, but in a dramatic change of fate we will have higher inflation as the interest rates will cause producers to mark their prices up or else lose margins. The first will cause inflation, second will cause market crash. In some sectors (steel, oil and cement) Indian government deliberately muscled in to cause the second.

In short, interest rate is a function of liquidity and productivity, and we are actually having a liquidity crunch in many sectors causing interest rates to spike which will also puke up the sectors that have been gorging money, like housing and auto loans. While, this could increase prices in the long term, it will reduce demand in the short and medium terms and cause asset depreciation thereby cooling the system.

Exchange rates:

Exchange rate control how much one good should be exchanged for to get another good, in a open market. For example, in a closed system if a farmer produces 10 kgs of rice and a gatherer produce 5 kgs of firewood, they both can exchange stuff on some fixed mechanism, say 1kg rice = 0.5 kg of firewood, so that both benefit from other's stuff. Now, if the farmer could produce 20kgs of rice, can he get 10 kgs of firewood from the market in this closed system? The answer is no. So, now the exchange rate would be adjusted such a way that 1kg rice = 0.25 kg of firewood. Thus, the price of firewood is said to be inflated, whereas it is actually the production of rice that is inflated 10 to 20kg and as a result its dependent exchange mechanism got changed. This is ECON 101.When you produce something more than the exchangeable limit, its value keeps going down and this is the natural process by which economies readjust and make things that are more valuable and productive. In the closed system case, the farmer could focus more energy on gathering some firewood too instead of overproducing rice.

This is all in open market (in 2 person system it ought to be), but are they true in complex real world markets? Not necessarily. The farmer can keep producing his 20 kgs of rice and then give it to the gatherer at the same exchange rate and each time he will get 5 kgs of firewood and 5kgs of firewood in I Owe You notice, which means he writes a paper in which he says he has to give the farmer 5kgs of firewood later (and in this closed case, it is impossible unless he finds a way to dramatically improve the yielf of firewood). This is the farce that is currently going on in the pegged exchage rate system done by Japan, China, Europe and others including India. Instead of allowing the exchange rate of Yen/Renmimbi/Rupee to Dollar (rice to firewood) to flow by natural process they just keep getting the stupid IOUs that the gatherer (USA) has no intention of paying back. But, it doesnt matter: by the time the crisis occurs the old men in the central banks would have died leaving us all in the jeopardy.

Now, what we like many other central banks have been doing is to keep getting IOUs from US (called dollars and T-bills) and right now we have more than $200b worth of them. This whole money has not dont much good to the country and it has just made the exporters like IT sector filthy rich. The appreciation of rupee could have reduced the cost of imports and increase rupee's value threby reducing inflation. But, instead of allowing rupee to appreciate when we got billions of dollars from investments and exports, what RBI did was to print trillions of rupees of money and got the dollars from the exporters and FIIs. Thus, our money supply went up by many trillions (2 to 3) in the last few months just because of this. In effect, indirectly we were subsidizing FIIs and exporters by putting domestic people to strain. And this has currently been stopped for a while, thereby appreciating the currency.

In essense, RBI is currently doing the right thing of allowing the rupee to float freely and the markets determine the exchange mechanism instead of just gorging on the dollars, that might not have any use if US falls.

So, how this twin effect of interest rate hike and exchange rate appreciation going to impact us? That's in part 3.