16 April 2011

Inflation and Interest Rates.

After a lot of posts on technical aspects of markets, I thought of taking a break from it. Just browsed through some macro economic data. I always get an urge to look back at data when our news channels give reasons for a market fall as high inflation, poor IIP number or interest rate hike. In my opinion markets are far too forward looking, most of the fundamental analysts look 3 years ahead and estimate earnings of a particular business. Also what we will see is that interest rates as well as inflation is not much of a local phenomenon these days.

Lets take a look at the above chart, which shows Interest rates and Inflation from Jan 2000. I will ignore pre 2000 macro conditions as I don't have much data to comment on it. Coming to the chart, we see that till 2005 end, inflation was very much a "domestic animal", tamed and mild. The monetary policy as well reflected the same calmness and relaxed attitude. At the beginning of 2005, we see the rate increasing (marked A in chart) and only period when RBI was ahead of curve, mostly because there was too much foreign money flowing in (stock market as well was roaring) and Indian economy was slush with liquidity. It was easy to get credit, but with too much of "hot money", RBI found it difficult to handle and started raising rates. Notice that initially there was not much impact on inflation (which was expected due to the money flow), but after 2006, it started rising and rarely fell below 6% till 2008, even though rates were increased to tackle it.

After Jan 2008, inflation was getting wild. It spiked to 10%, thanks to crude oil and other commodities. But look how RBI was sitting on its hand. Why? The housing bubble and had gone bust in the US, and all the easy money was gone. Foreigners were, (forget about putting money) taking out money from India. Had RBI raised interest rate at that time, growth would have been seriously challenged, at least RBI thought it will damage the economy if it raised rates.

But in late 2008, something more unconceivable happened. There was almost a total freeze of credit. RBI had to reduce rates dramatically in form of stimulus to spur the economy. Rates came down to below 4%, first time since 2000, inflation on the other hand totally ignoring the credit crisis, kept on galloping and lower rates pushed it even further (food was the key driver of inflation during this phase).

When it reached almost 16%, then only RBI had the guts to begin rate hike. Since then we are almost back to the easy money period rates, but inflation is still stubborn at over 8%. RBI and government still pledge to bring the inflation down, as it has been seen as a major political headache, but can they do anything more than tweaking the interest rates? Where on one hand inflation threatens business doers with increasing cost of operations, on the other hand high interest rates makes it difficult to get/afford credit.

Its very difficult and almost impossible to maintain a balance of interest rate and inflation, without hurting the economy much. Look at how US, China and Japan have been struggling to get a right balance of both. RBI have been favorably placed during last credit crisis, as oil a major import as well as inflation contributor after peaking almost collapsed, saving it from hiking rates. But will it be so, where crude oil is resilient over $100 and analysts predicting 200.

So, what we see is that, Indian inflation is much more a function of global macros than local supply-demand balance. Interest rates have been managed well by RBI, but still is dependent on what kind of money flow, India is getting. Going forward this will remain the case. If the world, is flooded with easy money (dollar), then inflation will be rampant and India will be a huge sufferer mainly because it will have to import commodities at a much higher price, which definitely is going to cause a slowdown in growth, as it will kill demand. On the other hand a credit crises again, though equally terrible, will be only punishing those, who do not have cash at hand.


manu said...

hi anwar..
r d figures coorect for intrst rate in 2000-14 and inflation 16 jan 201.1???
its academic query?
u hv taken data YOY,

Sriganeshh said...


good post. but conclusion need not be worst scene. high inflation and growth can go together if RBI manages the situation well.
OT, only difference is at that time Bimal Jalan and later Dr.Reddy was in control and they know the subject.

Sriganeshh said...


on rethinking, if you take inflation and interest data from 1996, what could be your views.
from mid 1997, rupee depreciated very alarmingly and RBI took drastic step of increasing all three..repo, bank rate and CRR on Jan 16, 1998 to arrest fall of rupee, which though had desired effect on rupee front but created mess in interest scenario. Keeping this background, if you can post your views, will be helpful.
Anyway, your effort deserves high appreciation.

Tarique Anwar said...

@manu i dont have these data, i have taken them from a respectable site (http://www.tradingeconomics.com) i think its based on CPI, i also got confused as july 2009 to sep 2009 had negative inflation due to base effect when calculated yoy.. i would love to see and alternate inflation chart..

Tarique Anwar said...

@Sriganeshh thanks for appreciation.. as i had already said.. they make me go on.. fundamentally i feel we have come into a very different and complex scenario, with a lot of moving parts.. earlier we had stricter monetary policies now anyone with a ton of dollar or yen can get into india and dump their easy money for higher returns here.. though they help growth (the reason why it has been allowed) they also heat up the demand and hence cause inflation worries.. also if you go back in history big bull markets have come in a period of low inflation and low interest rates.. higher interest rates always are a result of higher inflation.. it apparently show signs of growth but actually is a kind of source of collapse and bubble burst..

Tarique Anwar said...

just go by common sense as to what is happening in US.. interest rate is artificially kept low to boost growth, easy money goes more into speculation than to economy as no one has the courage to risk the money they got into a lame economy with high unemployment.. they know everyone else can get that easy money, so to protect that they put it into hard asset.. gold, oil agri commodities.. pushing inflation.. the fed has been printing money hoping to see some economic activity.. but all it sees is higher prices and a little growth.. the dollar is on the verge of collapsing and in case that happens.. expect to see 20% inflation in india.. tell me whether you will buy food or stocks ?!

manu said...

@anwar..nicely put but with sri exprnc u cant bet..

i also second that till d bubble will burst in US, no fear even if inflation @20..qe3/4 will cum up..join the joy ride but with caution..

u hv ever seen a single arrest after lehman or fat fingure in US..we r a true bakwass democratic set up..all biggies under judicial custody yesterday(bcoz d case s hyped)..

on other hand..
when interst rate cycle s high buying(domestic) food s not a problem but selling(business) food at such high intrst bcms prblm..

mo h said...

This is the most interesting intelligent discussion I have seen in the recent times.
I wish to see more from the three of you on fundas.
So, I will subscribe to this post comments by email.
Thanks Tariq,
You guys are great!.
My breaktime did NOT go a waste.
Have a great day.
and... Tariq, You got a great blog :)
I have your link at our site ever since.

Tarique Anwar said...

@ moh thanks for the encouragement.. if you are interested in more and with greater depth analysis and commentary on global macros, you can go through "zerohedge.com" those guys talk mostly pessimism but have great guests who write their opinions..

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