Inflation in terms of income and prices

Inflation has emerged as one of the key challenges of the world at this time. However we tend to reflect on inflation in terms of prices of basket of products and services. I think such a metric serves us to understand only a part of the problem.

Inflation, as we measure it today, does not measure social benefits when job scenario is difficult. The theory behind inflation posits that when the inflation becomes known wages should adjust to reflect the same. If wages are stable and prices start rising, inflation rightly triggers alarm bells. However, if prices are stable and incomes are falling then inflation data tends to mask the underlying decline in living standards.

Generally, policy makers use two variables, inflation and real average income growth, together. However, rarely do we see both variables in same discussion. The problem arises because of difference in measurement techniques of prices and wages. However, limitations of measurement should not be a cause for erroneous policy.

I think we need to define inflation as difference between wage rise and price rise. Or we may use another metric that measures this difference. I believe it should give a proper indication of the on-the-ground situation of the economy. 

Thus, in the developed world, with economies losing jobs, we expect this metric to expand conveying the increasing difficulty in sustaining a lifestyle. This comes over a decade of falling prices with stable incomes which we may parallel with deflation. 

How such a variable will influence policy response is a difficult question. However, it should definitely improve our understanding of the realities.

Market Timing Anxiety

During the start of the year I had written about wanting to move to cash. Indian equity markets subsequently crashed and are staring down a possible decline to 5400 levels on the Nifty. I did move into cash but just in nick of time. The result is that my gains are lower than what could have been had I exited without hesitating like I did.

Now I am faced with exactly opposite conundrum. A lot of stocks have started hovering around the "buy" level. But the Nifty is still at 5600 level with still about 200+ point decline a distinct possibility. I am waiting with baited breath. But waiting has it anxious moments. The high volatility implies that market moves in dramatic fashion making it difficult to watch. There is no apparent reason (one that has materialized since beginning of 2011). 

At such moments the noise on TV and within research reports is further unnerving. Goldman Sachs recently revised the target price of few stocks down by 20-35% and still rates the stock buy. Some stocks are already above their revised target price. I don't know if research quality has declined to this extent or is it my nerves. 

The TV anchors are busy retrofitting explanations to the market movements. I read three on tueday. Half an hour after the RBI policy markets gave it a thumbs up, an hour later markets behaved as if they had already priced-in the rate hike and by end of day RBI rate hikes had caused catastrophic slide in Indian equity markets. I think reporting levels have dropped beyond redemption. It may make sense to free up the bandwidth these channels occupy.

Anyways, are you waiting too? And do you feel as anxious?

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My book "Subverting Capitalism & Democracy" is available on Amazon

Why RBI could not raise interest rate more than 25bps?

Yesterday the Reserve Bank of India (RBI) announced hike in Repo and reverse repo rates by 25bps each. Some commentators argued that RBI is behind the curve and should be aggressive in rate hikes. I disagree.

India is not entering the Volcker age

The question of aggressive RBI puts the Indian economy in some ways (not in magnitude) similar to US when Paul Volcker became the Fed chairman. There is high demand side pull and supply side needs catch up. But there is a key difference in India's position.

India needs investments in supply infrastructure

India needs more than INR 2 Trillion worth of investments to de-bottleneck the supply side. I am not talking about creating supply but simply reducing wastage and time lags to ensure supply gets to consumer. This investment is required in roads, cold-chains, food processing, storage and markets etc. This infrastructure is government responsibility. Either government create this infrastructure or create conditions in which private player can create it. Without this not much can be achieved on supply side.

Interest rate puts pressure on this investment

By increasing interest rates in arbitrary manner RBI will create uncertainty that will impact these investments in two ways. First, it will postpone the investments because of uncertain business environment. Secondly, it will increase the cost of capital and thus reduce profitability of these investments.

Hence, I believe, the RBI acted prudently to signal inflation concerns but allow markets to steadily adjust to higher interest environment. 

Why did the US leverage itself so much?

There has been some discussion in the blogosphere about Peter Thiel's interview Back to the Future with Peter Thiel - Interview - National Review Online. One of the central question in the discussion is Why US leveraged itself to this extent - referring to the excess debt carried by US households. 

The question reminds me of an Aesop's fable about donkey and goat. A man is leading a donkey on a leash when a few people decide to play a prank on him. In turns one of them would appear to pass down the road and ask him why he is walking his goat instead of carrying it on his shoulders. After a few passes the person is convinced that his donkey is actually a goat and tries to carry it over his shoulders.

The same is situation with US consumers. Over time people have been telling the US consumer that loans to them are most safe. Over time US consumers were convinced that they can safely borrow more as future growth will take care of the repayment. The situation worked well for a generation and there was no reason to assume it was broken. So they never stopped even when the future growth was no longer certain. In fact US consumer continued borrowing despite evidence that with current policy (marked down exchange rates and export-oriented growth models) US is nearly certain to have de-growth.

As I mention in the book, the blame for the last leg of overextending consumer was the result of big-money. Big money required paper to play with and creating the paper implied creating real assets even when there was no demand. I think that makes Gary Shilling's ideas, particularly the one of selling consumer financiers, make lot of sense.

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My book "Subverting Capitalism & Democracy" is available on Amazon 

Adjusting money supply in aftermath of a crisis

The rapid expansion in monetary policy in the aftermath of current crisis was criticized by many. However, I believe it was necessary (combined with other things).

In my book I explained that inflation is a tax against status quo. It is designed to make it costly to simply hoard money. A crisis, often, results in inappropriate(1) accumulation of money. The accumulation often uses mechanism that do not create value. Inflation, in aftermath of such a crisis, may all those with genuine value creation mechanisms to rise above the scamsters.

Thus, increase in money supply seems desirable as it will nudge inflation while allowing money to move to value creators. However, this is contingent on a premise that new mechanisms are genuine and not simply new scams. The US has failed in ensuring this. That is why unemployment is high and rising while money sloshes around without effect.

Note:

(1) How we define inappropriate is another question for other time.

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My book "Subverting Capitalism & Democracy" is available on Amazon