Monday, September 21, 2015

US Fed chairman Janet Yellen and RBI governor Raghuram Rajan confront two faces of inflation -- low and high respectively




US Federal Reserve Chairman Janet Yellen did not increase interest rates as was feared by many in the emergent economy markets, especially in India. As a matter of fact, India’s pro-market pundits heaved a sigh of relief that Yellen did not change the rates because that would have caused flight of capital from the Indian bourses, at least in the short run. This would have made the task of Reserve Bank of India (RBI) Governor Raghuram Rajan’s difficult to respond to increasing pressure from government and industry to cut interest rates. The argument is now being put forward that since Yellen has not changed interest rates, it becomes easier for, even incumbent upon, Rajan to announce rate cut.

There is of course some connection what the US Fed does and what the RBI will do. It would have become necessary to factor in the US Fed’s decision if there had been a rate cut. It would be a matter of speculation what the RBI would have done. It would have had to delay further any thought of a rate cut. It has however to be recognised that the US interest rates would only be one of the factors, perhaps a slightly important one, But the important factor for any decision that Rajan would take would have depended on the state of the Indian economy. The main concern of Rajan and that of the RBI has been inflationary pressures, especially with regard to food prices. There has been a sharp decline in commodity prices, and that has partially helped in reducing the import bill, especially with regard to crude oil imports. But decline in export earnings has made created a stagnant situation though it has certainly helped in keeping under control the current account deficit.

It is interesting to note the argument offered by the US Fed with regard to keeping the interest rates -- 0 to 1/4 per cent -- unchanged. (At the Federal Open Market Committee, nine, including Yellen, voted in favour of keeping the rate at the present levels. There was a lone dissent vote preferring raising the rate by 25 per centage points.) The Fed’s press release says, “Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability...The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labour market and is reasonably confident that inflation will move back to its 2 per cent objective over the medium term.”

The US Fed has to keep the interest rates close to zero in the hope of boosting economic activity. For the Fed, the economic activity has to be reflected in “maximum employment” and “price stability”.

The Indian problem is of the opposite kind. It is the fear that the barely low levels of inflation arising partly out of cheaper commodity prices would jump if the interest rate is pushed down. ( The average rate of inflation in India for 2015 is at 5.96 per cent. According to another figure, it is 6.09 per cent for the year. There has indeed been a sharp decline in inflation from 9.99 per cent in 2013 to 5.99 per cent in 2014.) There will be greater credit off-take if the rates are revised downward and it may ensure greater economic activity but it may not translate into economic growth as such. Credit off-take which does not result in growth will spawn non-performing assets (NPAs) on the bank balance-sheets. And greater money circulation will lead, initially, into higher inflation levels. Unlike in the US, the Indian monetary policy is not bound by goals of maximum employment and price stability.

While the US Fed is waiting for the inflation rate to move up to 2 per cent, the RBI seems to be waiting for the inflation rate to hover comfortably low. It could be 5 per cent or sub-5 per cent. RBI deputy governor Urijit Patel has indicated that there is need for “sustained low inflation” as a basis for interest rate revision.

The expectation that Yellen’s refusal to raise rates in the US should enable Rajan to cut rates in India is too simplistic.


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