Sonaal Kohli: When Feel Good becomes Deep Wounds

Inflation and higher interest rates may wreck the economy

India is shining; however, the low interest rate regime coupled with a relatively high rate of inflation remains a question mark.

High inflation in the last decade has become a worldwide phenomenon, be it Latin America, Africa, Russia or south-east Asia. This time, the world over, the blame for high inflation is being conveniently passed on to rising oil and commodity prices, health care and education costs.

However, rising prices can never be a cause of inflation because inflation is defined as rise in prices. Rising oil and commodity prices are at best symptoms of the disease of inflation. The main cause of inflation is perhaps the monetary policies of the world governments.

To illustrate what causes inflation, let us assume that there is an island economy that has only five berries and five berry-notes with each berry-note entitled to one berry.

If the central banker of the island increases money supply to 10 berry-notes, this will make no difference in the final consumption of berries because the number of berries "" or the real capital of the island "" remains five.

With 10 berry-notes the purchasing power of berry-notes would only decrease, and one berry-note will now be entitled to only half a berry. This is what we call inflation. There are, however, three differences between inflation in the economy of a secluded island and the economies of nations.

First, in the economies of nations there is a time lag of a couple of years between an increase in money supply and inflation. An increase in money supply is generated by the central bank through the banking system "" by lowering the cash credit ratio, statutory liquidity ratio and so on.

With an increase in the money supply, the interest rate falls. With falling interest rates, part of this increased money supply flows to financial assets leading to asset inflation; for example, rise in prices of stocks, bonds and real estate. With reduced cost of borrowing on account of lower interest rates, part of this increased money supply is borrowed by entrepreneurs to start new projects.

Slowly, the money is routed from the entrepreneurs and the banks to the common man "" the consumer "" in the form of higher salaries and economical retail financing. The common man has a bad habit of pouring it in already-rising financial assets, adding fuel to the fire, causing rise of real estate and stock prices to unsustainable levels "" which is what happened in Japan, south-east Asia and the US.

Rising stock markets and higher salaries, although temporary, lead to the illusion that everyone has become richer. There is a "feel-good factor" all around.

The consumer feels good (financially secure) and starts saving less and less. With cheap retail financing and higher salaries, he starts borrowing more and more of the increased money supply, demanding more and more consumer goods.

There is a consumption boom all over. As existing capacities of producers are increasingly utilised because of the rising consumption demand, they start increasing prices and inflation eventually sets in.

The second difference between inflation in the economy of a secluded island and the economies of nations, is that countries that are able to import cheap consumer goods because of their artificially-strong currencies don't suffer from inflation for long periods of time despite an increase in money supply.

A good example of this is the US these days. It is only when market forces devastate their currencies that these economies suffer from hyperinflation.

Third, inflation remains hidden because of productivity gains. For example, productivity gains have led to a fall in the prices of electronic products.

In the UK, under the gold standard (when money supply was fixed), prices before World War I were half of that of a century earlier due to advances made in productivity.

In the last decade, if there was no increase in money supply, then prices the world over would have actually fallen. Therefore, to that extent, there is essentially a hidden inflation.

But why do the governments recklessly increase money supply? Democratically-elected governments need more and more money to spend on popular schemes like food, housing and water.

For political reasons, they cannot increase their revenues through higher taxes and, therefore, borrow. Governments, being the biggest debtors, benefit the most by lowering interest rates.

They, therefore, artificially reduce interest rates by increasing money supply. Lower interest rates result in rising financial markets and a feel-good factor, although temporarily, helping them gain public support in the elections.

After a couple of years of increase in money supply, inflation eventually sets in. Inflation destroys the purchasing power and savings of millions of people.

Due to high inflation, governments are eventually forced to reduce money supply and increase nominal interest rates. With high inflation (increased cost of projects) and high cost of borrowings, many projects become unviable and are closed midway for lack of funding. Now there is a "feel-bad" factor all around.

There is loss of jobs, stock and bond prices collapse, consumers reduce their spending, GDP growth rate falls and we have recessions.

For the last decade, governments the world over have been increasing money supply. In India too, for the past few years the Reserve Bank of India (RBI) has been continuously expanding money supply.

M3 (a measure of money supply) has increased by 70 per cent in the past four years, from about Rs 11 lakh crore to Rs 19 lakh crore.

This has led to lower interest rates. For example, the yield on 10-year Government of India bonds has fallen from more than 11 per cent in 2000 to about 5 per cent currently with lower borrowing costs, investments are being made by entrepreneurs in newer projects.

The consumer is spending more on account of cheap retail financing and higher salaries. The GDP is increasing; more and more money is being poured into the stock markets/real estate.

But inflation is creeping in slowly and the real rate of interest (nominal interest rate less inflation) is almost negative. A negative real rate of interest is certainly not sustainable. Either inflation has to fall or nominal interest rates have to rise.

In 1995, the Narasimha Rao government was forced to increase interest rates on account of high inflation, which eventually killed the economy for a decade.

With an eye on elections, the current Indian government is advised to avoid the same trap. It is, therefore, trying its best to rein in inflation. It was perhaps with this intention that the RBI didn't interfere in the recent appreciation of rupee against the dollar so as to reduce oil prices.

Recently, inflation may have fallen because of such proactive measures. It, however, remains to be seen whether after the elections, the current feel-good factor will last for long, or thanks to inflation and higher interest rates, it will change to a deep-wounds factor.

(The writer is analyst treasury, Indo Rama Synthetics and can be contacted at sonaalkohli@indiatimes.com. The views expressed here are personal.)