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Conflict Between Economic Growth and Inflation

by Tejvan Pettinger on April 24, 2009 in economics

Readers Question: What is the relationship between inflation & economic growth? If growth is caused by rising AD, then the growth is likely to cause inflation. This is because as the economy ,and therefore, firms approach full capacity they start to increase prices due to supply constraints. Wages will also start to rise because of the decline in unemployment; rising wages will cause both demand pull and cost push inflation. An example of high growth causing inflation was the Lawson boom of the 1980s. In this period economic growth reached 5% per year, this was much higher than the UKs long run trend rate of growth and caused inflation to increase to 11%.

Diagram of Demand Pull Inflation

Basically, If economic growth is above the long run trend rate (average sustainable rate of growth over a period of time) then inflation is likely to occur. Growth and Low Inflation. It is possible that we can have economic growth without causing inflation. If growth is caused by increased productivity and investment, then the productive capacity of the economy can increase at the same rate as Aggregate Demand. This enables economic growth without inflation. For example, since 1993, the UK has experienced low inflationary growth. This is partly due to economic growth being sustainable i.e. close to the 2.5% average; it is also due to productivity improvements such as privatisation and more flexible labour markets. Diagram showing Low Inflationary Growth

Low Inflation Causes Growth It is argued that low inflation can contribute to a higher rate of growth in the long term. This is because low inflation helps promote stability, confidence, security and therefore encourages investment. This investment helps promote long term economic growth. If an economy has periods of high and volatile inflation rates, then rates of economic growth tend to be lower.

High Inflation and Low Growth


It is possible that an economy can experience low growth and high inflation (e.g. in 2009, 2011)

This can occur if there is cost push inflation. Cost push inflation could be caused by rising oil prices. It increases costs for firms and reduces disposable income. Therefore, there is lower growth, whilst high inflation.

Economic Growth vs Inflation: Which is more Important?


by Tejvan Pettinger on October 28, 2008 in economics

Readers Question: Low inflation but slow economic growth, if any, or GDP growth , with the risk of 2 digits inflation? Which one is a better option,or the least harmful? The choice is not enticing. These are some point to consider: At the moment the UK economy is experiencing inflation of 5% (above the target of 2%) but economic growth has slowed down and we face the prospect of a recession. In this situation, the MPC has cut interest rates (so we have negative interest rates) This suggests two things: 1. They think the threat of recession and unemployment is more serious than a moderate rise in inflation 2. Inflation will fall next year as the economy moves into recession.

Cause of Inflation?
If inflation is caused by cost push factors (rising oil and energy prices) the Monetary authorities are more likely to agree to higher inflation. This is because with cost push inflation, we are faced with a worse trade off (aggregate supply shifts to the left). Also cost push inflation is more likely to be temporary. However, if the inflation is caused by demand pull factors, if economic growth is too fast, then the MPC may be more willing to raise rates and prevent the economy overheating. For example, in the Lawson boom, the economy grew rapidly allowing inflation to reach double figures. This boom then caused a bust. However, the alternative to the Lawson boom was a slower rate of growth (3% rather than 5%). This choice between 0% growth or 2% growth and high inflation, suggests the economy is facing a pretty difficult situation, with a combination of supply and demand side shocks.

Reasons to Target Inflation

There would be some who argue that it is better to keep inflation low, even if it means 0% growth. This is because low inflation is important for the long term success of the economy. It encourages investment and stable growth in the long term. If the authorities allow inflation to get out of control, it will only require a more painful readjustment in the future. Keeping inflation low may lead to 0% growth in short term, but, the economy should recover. (costs of Inflation)

The Importance Of Inflation And GDP


August 13 2010| Filed Under Ben Bernanke, Federal Reserve, Federal Reserve Board, Fiscal Policy,GDP, Inflation, Macroeconomics, Monetary Policy, Powerful Leader, Unemployment Rate Investors are likely to hear the terms inflation and gross domestic product (GDP) just about every day. They are often made to feel that these metrics must be studied as a surgeon would study a patient's chart prior to operating. Chances are that we have some concept of what they mean and how they interact, but what do we do when the best economic minds in the world can't agree on basic distinctions between how much the U.S. economy should grow, or how much inflation is too much for the financial markets to handle? Individual investors need to find a level of understanding that assists their decision-making without inundating them in piles of data. Find out what inflation and GDP mean for the market, the economy and your portfolio.

Terminology Before we begin our journey into the macroeconomic village, let's review the terminology we'll be using.

Inflation Inflation can mean either an increase in the money supply or an increase in price levels. Generally, when we hear about inflation, we are hearing about a rise in prices compared to some benchmark. If the money supply has been increased, this will usually manifest itself in higher price levels - it is simply a matter of time. For the sake of this discussion, we will consider inflation as measured by the core Consumer Price Index (CPI), which is the standard measurement of inflation used in the U.S.financial markets. Core CPI excludes food and energy from its formulas because these goods show more price volatility than the remainder of the CPI. (To read more on inflation, see All About Inflation,Curbing The Effects Of Inflation and The Forgotten Problem Of Inflation.)

GDP

Gross domestic product in the United States represents the total aggregate output of the U.S.economy. It is important to keep in mind that the GDP figures as reported to investors are already adjusted for inflation. In other words, if the gross GDP was calculated to be 6% higher than the previous year, but inflation measured 2% over the same period, GDP growth would be reported as 4%, or the net growth over the period. (To learn more about GDP, read Macroeconomic Analysis,Economic Indicators To Know and What is GDP and why is it so important?)

Watch: Inflation
The Slippery Slope The relationship between inflation and economic output (GDP) plays out like a very delicate dance. For stock market investors, annual growth in the GDP is vital. If overall economic output is declining or merely holding steady, most companies will not be able to increase their profits, which is the primary driver of stock performance. However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money (and future corporate profits) less valuable. Most economists today agree that 2.5-3.5% GDP growth per year is the most that our economy can safely maintain without causing negative side effects. But where do these numbers come from? In order to answer that question, we need to bring a new variable, unemployment rate, into play. (For related reading, see Surveying The Employment Report.)

Studies have shown that over the past 20 years, annual GDP growth over 2.5% has caused a 0.5% drop in unemployment for every percentage point over 2.5%. It sounds like the perfect way to kill two birds with one stone - increase overall growth while lowering the unemployment rate, right? Unfortunately, however, this positive relationship starts to break down when employment gets very low, or near full employment. Extremely low unemployment rates have proved to be more costly than valuable, because an economy operating at near full employment will cause two important things to happen: 1. Aggregate demand for goods and services will increase faster than supply, causing prices to rise.

2. Companies will have to raise wages as a result of the tight labor market. This increase usually is passed on to consumers in the form of higher prices as the company looks to maximize profits. (To read more, see Cost-Push Versus Demand-Pull Inflation.) Over time, the growth in GDP causes inflation, and inflation begets hyperinflation. Once this process is in place, it can quickly become a self-reinforcing feedback loop. This is because in a world where inflation is increasing, people will spend more money because they know that it will be less valuable in the future. This causes further increases in GDP in the short term, bringing about further price increases. Also, the effects of inflation are not linear; 10% inflation is much more than twice as harmful as 5% inflation. These are lessons that most advanced economies have learned through experience; in the U.S., you only need to go back about 30 years to find a prolonged period of high inflation, which was only remedied by going through a painful period of high unemployment and lost production as potential capacity sat idle. "Say When" So how much inflation is "too much"? Asking this question uncovers another big debate, one argued not only in the U.S,. but around the world by central bankers and economists alike. There are those who insist that advanced economies should aim to have 0% inflation, or in other words, stable prices. The general consensus, however, is that a little inflation is actually a good thing.

The biggest reason behind this argument in favor of inflation is the case of wages. In a healthy economy, sometimes market forces will require that companies reduce real wages, or wages after inflation. In a theoretical world, a 2% wage increase during a year with 4% inflation has the same net effect to the worker as a 2% wage reduction in periods of zero inflation. But out in the real world,nominal (actual dollar) wage cuts rarely occur because workers tend to refuse to accept wage cuts at any time. This is the primary reason that most economists today (including those in charge of U.S. monetary policy) agree that a small amount of inflation, about 1-2% a year, is more beneficial than detrimental to the economy.

Watch: Monetary Inflation

The Federal Reserve and Monetary Policy The U.S. essentially has two weapons in its arsenal to help guide the economy toward a path of stable growth without excessive inflation;monetary policy and fiscal policy. Fiscal policy comes from the government in the form of taxation and federal budgeting policies. While fiscal policy can be very effective in specific cases to spur growth in the economy, most market watchers look to monetary policy to do most of the heavy lifting in keeping the economy in a stable growth pattern. In the United States, the Federal Reserve Board's Open Market Committee (FOMC) is charged with implementing monetary policy, which is defined as any action to limit or increase the amount of money that is circulating in the economy. Whittled down, that means the Federal Reserve (the Fed) can make money easier or harder to come by, thereby encouraging spending to spur the economy and constricting access to capital when growth rates are reaching what are deemed unsustainable levels.

Before he retired, Alan Greenspan was often (half seriously) referred to as being the most powerful person on the planet. Where did this impression come from? Most likely it was because Mr. Greenspan's position (now Ben Bernanke's) as Chairman of the Federal Reserve provided him with special, albeit un-sexy, powers - chiefly the ability to set the Federal Funds Rate. The "Fed Funds" rate is the rock-bottom rate at which money can change hands between financial institutions in theUnited States. While it takes time to work the effects of a change in the Fed Funds rate (or discount rate) throughout the economy, it has proved very effective in making adjustments to the overall money supply when needed. (To continue reading about the Fed, see Formulating Monetary Policy,The Federal Reserve and A Farewell To Alan Greenspan.)

Asking the small group of men and women of the FOMC, who sit around a table a few times a year, to alter the course of the world's largest economy is a tall order. It's like trying to steer a ship the size of Texas across the Pacific - it can be done, but the rudder on this ship must be small so as to cause the least disruption to the water around it. Only by applying small opposing pressures or releasing a little pressure when needed can the Fed calmly guide the economy along the safest and least costly path to stable growth. The three areas of the economy that the Fed watches most diligently are GDP, unemployment and inflation. Most of the data they have to work with is old data, so an understanding of trends is very important. At its best, the Fed is hoping to always be ahead of the curve, anticipating what is around the corner tomorrow so it can be maneuvered around today.

The Devil Is in the Details There is as much debate over how to calculate GDP and inflation as there is about what to do with them when they're published. Analysts and economists alike will often start picking apart the GDP figure or discounting the inflation figure by some amount, especially when it suits their position on the

markets at that time. Once we take into account hedonic adjustments for "quality improvements", reweighting and seasonality adjustments, there isn't much left that hasn't been factored, smoothed, or weighted in one way or another. Still, there is a methodology being used, and as long as no fundamental changes to it are made, we can look at rates of change in the CPI (as measured by inflation) and know that we are comparing from a consistent base.

Implications for Investors Keeping a close eye on inflation is most important for fixed-income investors, as future income streams must be discounted by inflation to determine how much value today' money will have in the future. For stock investors, inflation, whether real or anticipated, is what motivates us to take on the increased risk of investing in the stock market, in the hope of generating the highest real rates of return. Real returns (all of our stock market discussions should be pared down to this ultimate metric) are the returns on investment that are left standing after commissions, taxes, inflation and all other frictional costs are taken into account. As long as inflation is moderate, the stock market provides the best chances for this compared to fixed income and cash.

There are times when it is most helpful to simply take the inflation and GDP numbers at face value and move on; after all, there are many things that demand our attention as investors. However, it is valuable to re-expose ourselves to the underlying theories behind the numbers from time to time so that we can put our potential for investment returns into the proper perspective.

Inflation Vs Growth
Let me start by defining what Inflation is: the rate at which the general level of prices for goods & services soar which means the purchasing power of the country surges. Generally, a country tries to maintain single digit inflation rate, but perhaps a low inflation rate can also be a downside for a country. To control inflation, the central bank does tighten the monetary policy e.g. increase in the interest rate. An increase in the interest rate has a side effect of curtailing the investment & employment leading to a slump in growth. India saw a sharp downfall in growth for about 5 years after higher interest rates during 1995-96. The tussle always subsists between Inflation & Growth in any country, especially developing economies. There exists one school of thought which says that higher interest rates contain inflation & another school of thought says that lower interest rates lead to better growth. Bone of contention!! For instance, recently RBI went for 2 subsequent hikes of interest rate with a hike of 25 bps on repo & reverse repo rate on 2ndof July & another 25 bps on 27thof July to contain the inflation. But being a little pragmatic, as expressed earlier, higher interest rates can lead to

unemployment, so a person would prefer a low paying job with 12% of inflation rather than no job. So I put myself in the second school of thought, higher growth with less interest rate & inflation. But is this possible? India uses CPI (Consumer Price Index) for the calculation of Inflation rate. With over a billion of people, quality food for all seems to be a distant dream. This is predominantly because of higher food prices which a common man finds it difficult to pay. So containing food inflation is the first step towards curbing the inflation in our country. There are two strategies to curtail food inflation keeping the interest rates at bay. This will indeed check the sustainability of the agricultural sector as India is primarily dependent on agriculture. 1. Enhancing the productivity of farms 2. Improved Public Distribution System (PDS) Enhancing the productivity of farms: Our agriculture chiefly depends on monsoons: we are betting on a good monsoon this time which can indeed leave a positive impact on food inflation. But chasing the monsoon each year is simply unfeasible. So improving the productivity of our farms will give a better yield & thus lower the prices of food. A study predicts that there is 6% increase in water consumption by agriculture sector by 2025. So the sustainability question is how to yield better with less usage of water or resources in general? Firstly, practice of effective use of resources like water, energy. Average farm size of India is 2.3; with 80% of the farms under 2 hectares. Predominantly Indian agricultural system uses flood irrigation which consumes three times more water than it should. So, low cost drip irrigation & use of treadle pump for irrigation is best for small plots. They are cost efficient & consume less energy & water. Secondly, investment on R&D in the agriculture sector should be increased & made more effective. For instance, China along with researchers in Philippines has developed aerobic rice, a new way of growing rice in water shortage areas. So we should also concentrate on situation based innovation in this sector. For that the government should invest in effective R&D. Third, agro business houses should take initiatives to enhance the production of the farms in our country & make it an attractive industry to work in by corporate tie-ups. There is an intimidation for shortage of skilled human resource base for farming as people are migrating to cities for better prospects or national acts such as NREGA which is attracting many farmers. For instance ITCs agro business has joined hands with ICAR (Indian Council for Agricultural Research) to promote nutrition rich sorghum using e-choupal facilities. This kind of corporate bonding with agriculture would give confidence for the human resource to work & progress. So these 3 main conducts can better enhance the productivity of agricultural farms. Improved Public Distribution System (PDS): Despite India ranking 2nd in the farm output & 2nd largest producer of vegetables & fruits, food inflation is high. This calls for a better supply chain of food products, Public Distribution System. For instance, 17.8 MT of wheat are lying with Food Corp of India (FCI) in open plinths, prices have escalated despite the huge buffer stock. A fresh estimate from the ministry of food processing says a whopping Rs 58,000 crore (Rs 580 billion) worth of agriculture food items get wasted in the country every year. So India seems to be a largest producer of food products but not the largest supplier. There has to be a complete revamp in the current supply chain system. First, procurement should be done without intermediaries & with

complete transparency. Second, Logistics & Warehousing in which the system calls for huge investment. This can be improved by having better cold storage units, silo system for different products, deployment of efficient manpower to take care of the same. Third, Distribution model in which the government has to revamp the way it worked by enabling technology in place. Proper deployment of technology like biometrics can improve on the system by reducing flaws like corruption & authoritative burglaries. So these 3 conducts can better reduce the wastage of food products which is directly proportional to food inflation. These practices which are not insurmountable can bring about a positive change in growth of our country without having inflation as bane. For a better tomorrow, we ought to follow such sustainable practices to cater the growing population. If small potholes like this along the way are filled, we could easily build a smarter India. Sharanarthy Jaswanth, BLP 2011

Falling growth, high inflation risks to stability: RBI


(Reuters) - Risks to India's macro-economic stability have increased on the back of an economic slowdown, high inflation, and ballooning fiscal and current account deficits, the Reserve Bank of India said in a report on Friday.
A slowdown in both domestic savings and investment demand, as well as a moderation in consumption have also emerged as threats to macroeconomic stability, the central bank said in its financial stability report (FSR). "The overall macro-economic risks in the Indian financial system seem to have increased since the publication of the previous FSR in June 2012," the RBI wrote in the report. India's economy is expected to grow 5.7-5.9 percent for the fiscal year ending in March, the slowest since 2002/03. Growth prospects also remain below the recent trend of double-digits, with Prime Minister Manmohan Singh this week calling the five-year government plan for 8 percent expansion "ambitious." The current account deficit also remains a concern as Asia's third largest economy has seen exports fall due to weak demand in key markets like the United States and Europe, while imports of gold and oil have remained high. On the fiscal side, the government could see a shortfall in tax and non-tax revenue because of the economic slowdown, and is at risk of overshooting its expenditure targets, the RBI said. The RBI added data from banks showed a significant portion of foreign exchange exposures at companies remained unhedged, posing another risk to macro-economic stability. "This is especially disquieting given that the exchange rate volatility has been higher in India in comparison to other emerging market currencies as well as those of advanced economies," the central bank wrote in the report. The RBI also said profitability at banks may come under pressure in coming quarters with gross non-performing assets (NPA) continuing to tread above the credit growth and on the back of rising slippages. State-run banks saw a high degree of deterioration in asset quality compared with its peers. The gross NPA for all banks rose to 3.6 percent at the end of September versus 2.9 percent at the end of March, the central bank said. The RBI said if the adverse macroeconomic conditions persists, the system level gross NPA could rise from 3.6 percent at end of September to 4 percent by end of March 2013 and 4.4 percent by end of March 2014.

(Reporting by Shamik Paul; Editing by Rafael Nam)

RBIs inflation vs growth conundrum


A succinct appraisal of the fiscal policy that the Reserve Bank of India has begun inserting in its macroeconomic and monetary survey every quarter is the most significant change that has crept into its quarterly pre-credit analysis, of late. More than any other section, this analysis has developed into an excellent read of how the monetary authority evaluates the response by the fiscal authority (New Delhi) to the twin challenges of keeping growth at a high level and inflation under control. The Bank this time goes on to list ten sets of fiscal measures the government took in a three week slab from September 13 to October 5. For each set the RBI observations show it is more impressed with those like reduction in diesel subsidy though it acknowledges inflation could rise in the near term and the proposed disinvestment in public sector units. It is more muted in appreciating what the government thought were more big bang reform measures like FDI in multi-brand retail. The bank observation is this will create "Moderate FDI inflows likely over next 1 3 years in retail. This will improve organised retail penetration, but its market share may still remain less than 10 per cent". Significantly the RBI does not include the Shome committee recommendations in the same period on GAAR in this list of fiscal measures, though the stock markets were hugely impressed. These differences notwithstanding the RBI conclusion is clear. "The dampened investment climate may revive gradually following the demonstrated intent for fiscal policy reforms and commitment to much-awaited active policy to propel the economy forward". And that gives an excellent pointer on whether Mint Street would move beyond the liquidity enhancing steps it announced in two tranches, slashing the cash reserve ratio by 25 basis points each time in July and September.

Uday Kotak, Executive Vice-Chairman & Managing Director, Kotak Mahindra Bank, says a combination of fiscal deficit and monetary

policy play will determine future market movement. Ahead of the three-day Kotak Annual Global Investor Conference that begins today, Kotak spoke to Udayan Mukherjee of CNBC TV18. Edited excerpts: What is your sense of the equity markets in 2013, given that 2012 was surprisingly good? One has to see how the combination of fiscal deficit and the monetary policy plays together. Europe has taken steps like gradual austerity and easy monetary policy . India is finally moving towards fiscal tightening. But this has to be done gradually because if it happens too fast, it can affect growth. At the same time, one has to watch how the monetary policy pans out, because unlike Europe, India also lives with high inflation. Therefore, the challenge is how to ease monetary policy when the fisc is correcting gradually and handling inflation. How markets will behave depends on how the policy responds to these challenges. Will fiscal adjustment come at a heavy price of seeing tepid growth?

When you tighten the fisc, it obviously has an implication on short-term growth, while the long- term economy gets healthier. So that's a tricky one, specially when you are one year away from elections. The key issue is how do we handle monetary policy when you have a large current account deficit and high inflation. If you were in the shoes of the policy makers, how would you play it? The policy makers may have to take a risk on at least one parameter -- either inflation or growth. I think fisc containment has to be gradual. What I would like to see is a more moderated improvement in the fiscal deficit. Has global investor perception on India improved dramatically from the pre-September period, as you begin your annual conference today? We have got a very good response, as around 500 participants from various institutions in India as well as overseas are attending the conference . There is an air of expectation that India is finally moving on a more positive track on the policy front. Corporate interest in meeting investors is at a record high. Over three days, 4,000-5,000 meetings will take place. In 2012, India got $24 billion foreign inflows which surprised many people. This year has started on an even better note. Do you expect 2013 to be a bigger year in terms of liquidity flows? Global liquidity is easy. The sense from Davos is that there is relief and no imminent worry of a crisis. Interest rates around the world are low, so liquidity will flow where it sees opportunity. The issue from an Indian point of view is how do you balance fisc tightening, handling inflation therefore monetary policy while at the same time give growth to investors. Its a very tough combination to handle. But if we can make a reasonable progress on this, money will come. India's current account is an issue and trade deficit numbers indicate that we have a run rate of $240-250 billion of trade deficit in a year. Therefore, portfolio flows are no longer just welcome, they are necessary. How much of these flows will get into the secondary market like it did in 2012, and how much of it will get soaked by issuance of fresh paper. We have seen a lot of this already at the start of the year. Divide the issue of paper into three parts. First, government companies they will have a reasonable flow of that paper even next year, if we have a handle on our fiscal deficit. Second, real sector companies, particularly those in the infrastructure sector. Due to high level of debt, the equity values at which many of these companies are trading are very thin; so most of the promoters will find it difficult to issue equity at this valuation and keep reasonable ownership of their companies. Third, the banking and financial institutions from where we recently saw a lot of paper coming in and more will come in. I think currently investors are more comfortable with this paper and there will be a reasonable supply of such paper in 2013. Do you think banks and other financial intermediaries will be able to profitably deploy the funds they are raising? So far, loan growth is quite tepid and investment plans have not yet started picking up. Will we see a turnaround in the investment climate? Right now, some of the banks may need to raise capital which will give a lifeline to many leveraged companies. So, some banks may raise capital to provide a breather for the real sector which is under pressure. What is the sense you are getting when you talk to companies? While the stock market is just 8% short of an alltime high, somehow CEOs dont seem to be exuding that confidence. First of all, stock market is nominal value and we are talking about five years later; so you got to discount it for inflation and look at the present value. I would be cautious to see the stock market at an all-time high in nominal terms to see what is happening in the real economy. I think in the real economy, corporate India is certainly moving slow. We need to keep the market in good shape to aid the real economy. We have made progress to keep the market in reasonable shape, but still translation of that to the real economy is not happening. Are you surprised by the reluctance of the entire retail and HNI fraternity to participate in the equity market? India is going through a paradox. We are importing foreign savings into Indian equities and exporting Indian savings into foreign gold. It is an amazing paradox. I think there is a sense of disillusionment in terms of the performance of companies. Though the market is close to its nominal high, many companies are above their five-year highs. But there are even more companies which are between 60-80 per cent lower than what they were five years ago. That is a problem.

Do you see this trend changing, or do you see this story of two halves continuing -- foreigners being bullish on India and locals continuing to be bearish? I think the local investor has a much higher hurdle rate for his or her return versus what the equity markets are promising to give. If you can get 8.5-9 per cent post-tax returns though various instruments that are available in the market today, youre talking about 12-13 per cent pre-tax hurdle rate for a domestic investor. Compare that with a foreign investor who is getting very little on his dollar money. Yes, there is a currency issue but lets keep that aside for the moment. Therefore for a local investor, the hurdle rate of return he is getting on his debt instrument is a significant barrier to make a choice in equities. Second, a lot of informal money is now out of equity market and is moving o other markets -- real estate, gold and commodities. Currency is a big factor for global investors and in the last three years, it has taken away a lot of equity market from India. How do you map the rupee? The rupee is linked to what we do on the macro, particularly on the fiscal side and the current account side. The current account is showing some signs of pressure and if I had to take a call on the currency for 2013, I dont see either 50 or 60. Are you expecting a slew of banking licences this year? The FM mentioned a possibility of four or five new bank licences. The process will take one-and-a half to two years before the new banks are in the business. How do you see this year for banking? Its a tale of two halves -- the way private sector banks have performed and the way PSU banks have performed. Do you expect this divergence to continue? I think the banking business is pretty simple. When you are a significantly leveraged player, equity can be very virtuous or vicious because leverage can change the game for any highly-leveraged institution. Therefore with respect to banks, I think the balance sheets are far more critical than short-term P&Ls. Investors will differentiate where they believe that balance sheets are robust, believe in the book values, believe in quarterly numbers and on relative basis see softer stress levels on the balance sheet. I think investors wants to see this comfort through 2013. How much of a reduction in interest rates do you expect in 2013? Where would your greater comfort lie this year, fixed income or equity? Policy rates by the end of 2013 should be about 7 per cent. That will fuel decent returns on bonds in the short term, but finally once you come down the curve, it will help investors to take a call on equities. I think the equity markets will also see a very sharp divergence between what investors perceive as quality and what investors are cautious about. And the quality part of the market is relatively a small segment, and it is choosing those companies which have a bottom-up approach, as distinct from buying India topdown which is a big difference I see in the marketplace.

HOW RBI CONTROL POLICY RATES AND INFLATION?


RBI raised the policy rates by 25/50 basis points. This is the most familiar statement in media for last couple of months. The role of RBI seems to have increased recently since India started experiencing major inflationary pressure on her economy. What exactly RBI intends to achieve by raising policy rates, also known as repo and reverse repo rate. We will make some sense of these moves by RBI and discuss the implication of it. Monetary function One of the functions of RBI is monetary policy structuring and implementation. The core focus of monetary policy is to increase or reduce the money supply in the market. The only way to do it is to increase or reduce the repo and reverse repo rate. Repo rate is the rate at which banks borrow money from RBI and reverse repo is the rate at which RBI borrows money from the bank. Now what does RBI intend to achieve by changing these rates. Lets look at how increasing and reducing the repo and reverse repo rates affect the market. If the policy rates are higher, the cost of money for banks is high. This means that the banks will charge higher interest rate for loans. The banks will also provide high rates to depositors.

If the depositors get good rates, this will encourage people to deposit money in banks. People will prefer saving because of the good returns that banks promise. This will reduce money in the market thus impacting consumption. Similarly, when the banks start charging high rates for lending, this will discourage people from borrowing. People will postpone their purchases of home, vehicles, and other items because of high lending rates on their home loans,personal loans and car loans. This will again reduce money supply thus impacting consumption. RBIs objective vis--vis policy rate RBI intends to do the same thing by increasing the repo and reverse repo rates. The money supply will be reduced and hence consumption will go down. If the consumption goes down, producers will reduce the price of goods to attract buyers to increase consumption. This will reduce the overall prices of commodities and other goods. Since India is facing high inflation for last couple of years, RBIs chief objective is to reduce the inflation by reducing money supply in the market. This explains why RBI increased the policy rates 11 times since early days of 2010. Price stability has become the main objective for RBI. Growth versus Inflation debate The unhindered increase in policy rates has resulted in reduced growth projection of the Indian economy. As consumption goes down, producers do not see much incentive in producing more. This impacts the overall gross domestic products. Hence the growth rate goes down as a consequence of RBI raising the policy rates. Many experts have warned that the move of RBI is going to have little or no impact on inflation because inflation is caused by supply side constraints and increasing oil prices. RBI has no control over both these factors. This argument does sound credible as we still do not see ease in prices despite so many increases in the last few months. The other school of thought says that the inflation has been at least capped and has not been allowed to go further up because of RBIs move. It is really difficult to say who is right as these are post facto observation. On hindsight, we can conclude whether the intended change was effected. However, when you have to plan keeping future in mind, nobody can be sure of the effect. Finally Slower than expected growth in developed economies has reduced commodity prices across the world. Oil has come down. This will ease the inflation in India too and take off some of the pressure from RBI. Hopefully, RBI will not have to increase the policy rates further.

Role of RBI in Indian economy 1. Issuer of currency Except for issuing one rupee notes and coins, RBI is the sole authority for the issue of currency in India. The Indian government issues one rupee notes and coins. Major currency is in the form of RBI notes, such as notes in the denominations of two, five, ten, twenty, fifty, one hundred, five hundred, and one thousand. Earlier, notes of higher denominations were also issued. But, these notes were demonetized to discourage users from indulging in black-market operations. RBI has two departments - the Issue department and Banking department. The issue department is dedicated to issuing currency. All the currency issued is the monetary liability of RBI that is backed by assets of equal value held by this department. Assets consist of gold, coin, bullion, foreign securities, rupee coins, and the government s rupee securities. The department acquires these assets whenever required by issuing currency. The conditions governing the composition of these assets determine the nature of the currency standard that prevails in India. The Banking department of RBI looks after the banking operations. It takes care of the currency in circulation and its withdrawal from circulation. Issuing new currency is known as expansion of currency and withdrawal of currency is known as contraction of currency.

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Banker to the Government RBI acts as banker, both to the central government and state governments. It manages all the banking transactions of the government involving the receipt and payment of money. In addition, RBI remits exchange and performs other banking operations. RBI provides short-term credit to the central government. Such credit helps the government to meet any shortfalls in its receipts over its disbursements. RBI also provides short term credit to state governments as advances. RBI also manages all new issues of government loans, servicing the government debt outstanding, and nurturing the market for governments securities. RBI advises the government on banking and financial subjects, international finance, financing of five-year plans, mobilizing resources, and banking legislation.

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Managing Government Securities Various financial institutions such as commercial banks are required by law to invest specified minimum proportions of their total assets/liabilities in government securities. RBI administers these investments of institutions. The other responsibilities of RBI regarding these securities are to ensure -

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Smooth functioning of the market Readily available to potential buyers Easily available in large numbers Undisturbed maturity-structure of interest rates because of excess or deficit supply Not subject to quick and huge fluctuations Reasonable liquidity of investments Good reception of the new issues of government loans Banker to Other Banks The role of RBI as a banker to other banks is as follows: Holds some of the cash reserves of banks Lends funds for short period Provides centralized clearing and quick remittance facilities RBI has the authority to statutorily ensure that the scheduled commercial banks deposit a stipulated ratio of their total net liabilities. This ratio is known as cash reserve ratio [CRR]. However, banks can use these deposits to meet their temporary requirements for interbank clearing as the maintenance of CRR is calculated based on the average balance over a period.

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Controller of Money Supply and Credit In a planned economy, the central bank plays an important role in controlling the paper currency system and inflationary tendency. RBI has to regulate the claims of competing banks on money supply and credit. RBI also needs to meet the credit requirements of the rest of the banking system. RBI needs to ensure promotion of maximum output, and maintain price stability and a high rate of economic growth. To perform these functions effectively, RBI uses several control instruments such as -

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Open Market Operations Changes in statutory reserve requirements for banks Lending policies towards banks Control over interest rate structure Statutory liquidity ration of banks

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Exchange Manager and Controller RBI manages exchange control, and represents India as a member of the international Monetary Fund [IMF]. Exchange control was first imposed on India in September 1939 when World War II started and continues till date. Exchange control was imposed on both receipts and payments of foreign exchange. According to foreign exchange regulations, all foreign exchange receipts, whether on account of export earnings, investment earnings, or capital receipts, whether of private or government accounts, must be sold to RBI either directly or through authorized dealers. Most commercial banks are authorized dealers of RBI.

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Publisher of Monetary Data and Other Data RBI maintains and provides all essential banking and other economic data, formulating and critically evaluating the economic policies in India. In order to perform this function, RBI collects, collates and publishes data regularly. Users can avail this data in the weekly statements, the RBI monthly bulletin, annual report on currency and finance, and other periodic publications.

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Promotional Role of RBI Promotion of commercial banking Promotion of cooperative banking Promotion of industrial finance Promotion of export finance Promotion of credit to weaker sections Promotion of credit guarantees Promotion of differential rate of interest scheme Promotion of credit to priority sections including rural & agricultural sector.....