Do it yourself: Inflation

Showing posts with label Inflation. Show all posts

Wednesday, August 20, 2025

Should the market be celebrating low inflation?

In July 2025, India’s consumer price inflation (CPI) hit an eight year low of 1.55% (yoy). Several factors contributed to the fall in inflation, including, a favorable base effect, lower fuel inflation, and decline in beverages and food prices. Since the inflation is much below the RBI tolerance range of 4% to 6%, it has excited the market participants about another rate cut at the RBI’s October 2025 Monetary Policy Committee (MPC) meeting. The prospect of lower Goods and Services Tax (GST) rates from November 2025, which could keep inflation subdued further, has added fuel to the speculations.

However, notwithstanding what RBI does at its next meeting, we need to answer a fundamental question - Is this low inflation—or even disinflation—a desirable thing for a growing economy like India?

Positive side of low inflation

Boost to Consumer Spending: Lower prices for essentials like vegetables and pulses mean more disposable income, which could spur consumption in a country where private spending drives nearly 60% of GDP.

Room for RBI Rate Cuts: Low inflation gives the RBI wiggle room to cut rates further, potentially by 25 basis points in October, reducing borrowing costs for businesses and homebuyers. Cheaper loans could ignite investment and housing demand, key pillars of India’s growth story.

GST relief on the horizon: Hopes of lower GST rates from November 2025 could be a game-changer. A reduction in GST, especially on essentials (which make up ~46% of the CPI basket), could keep inflation in check, further boosting purchasing power. This could amplify the RBI’s efforts to stimulate growth without stoking price pressures.

For a growing economy like India, projected to grow at 6.5-7% in FY26, low inflation creates a stable environment for businesses to plan investments and for consumers to spend confidently. No wonder markets are abuzz with optimism.

Why low inflation might be a problem

Low inflation, or worse, disinflation (a slowing rate of inflation), isn’t always a sign of economic health. For a dynamic economy like India, aiming to scale manufacturing and infrastructure, persistently low inflation could spell trouble.

Dampening capex enthusiasm: Low inflation often signals weak demand or excess supply. If prices stay too low, businesses may hesitate to invest in new factories, machinery, or tech upgrades—key drivers of capacity addition (capex). Why expand when profit margins are squeezed, and demand looks shaky? India’s GDP growth is already lacking triggers for acceleration, and a prolonged low-inflation environment could further sap corporate confidence.

Savings take a hit: Low inflation often leads to lower interest rates, as seen with the RBI’s recent cuts. While this is great for borrowers, it’s a blow to savers. Fixed deposits and small savings schemes, mainstay of Indian households’ savings, yield less in a low-rate regime. With real returns (adjusted for inflation) shrinking, households might cut back on savings, which fund bank lending and, ultimately, investment. India’s gross domestic savings rate, already down to 30.2% of GDP in FY24, could face further pressure.

Deflationary risks: If inflation dips too low—say, into disinflation or outright deflation—consumers might delay purchases, expecting prices to fall further. This could trigger a demand slump, hitting sectors like consumer durables and retail hard. Japan’s “lost decades” serve as a cautionary tale of how deflation can choke growth.

RBI’s warning bell: The RBI’s latest monetary policy review projects inflation rising to 4.6% in Q1 FY26, driven by potential food price spikes and global pressures like US tariff hikes (impacting 10.3% of the CPI basket). If businesses and consumers bank on low inflation now, only to face a sudden uptick, it could disrupt planning and erode confidence.

The GST wildcard

The anticipated GST rate cut from November 2025 could tilt the scales. Lower GST on essentials could keep inflation below the RBI’s projections, supporting consumer spending and giving the RBI more room to ease rates.

For instance, a 1% reduction in GST on food items could shave 0.1-0.2% off headline inflation, based on historical studies. This would be a boon for growth, especially in rural areas where food dominates household budgets.

But there’s a catch. Lower GST could reduce government revenue, limiting fiscal space for infrastructure spending—a key driver of India’s capex cycle. Plus, if global commodity prices or US tariffs spike, imported inflation could offset GST’s deflationary impact, forcing the RBI to rethink rate cuts.

Conclusion

Low inflation could be an opportunity as well as a challenge for India. In the short-term, it’s a tailwind—cheaper goods, lower borrowing costs, and potential GST relief could juice up consumption and growth. But sustained low inflation risks stifling capex and savings, which India can’t afford. The RBI’s cautious outlook for FY26, coupled with external risks, suggests it will tread carefully, likely opting for a modest 25-basis-point cut in October rather than aggressive easing.

Investors should watch the October MPC meeting closely and track GST reform updates. Sectors like consumer goods and banking could benefit from lower rates and higher spending, but keep an eye on capex-heavy industries like infrastructure and manufacturing for signs of slowdown. For now, enjoy the calm—but don’t bet the farm on it lasting.

Wednesday, June 18, 2025

Where did we lose our way?

My engagement with Indian financial markets began in the late 1980s, at a time when the winds of reform had just started sweeping through the economy. What followed in the 1990s was a structural reset — the kind that lays the foundation for decades of growth, even if its full implications aren’t immediately visible.

The decade of 1990s witnessed –

(i) An overhaul of the financial sector with abolition of capital controls, opening of doors for the foreign portfolio investors, entry of private banks in the markets, material liberalization of the rules for non-bank lenders (NBFCs); laying foundation for pension and insurance sector reforms;

(ii) Significant liberalization of the industrial licensing system; material dilution of the Monopolies and Restrictive Trade Practices Act and Foreign Exchange Regulation Act, de-reservation of several articles from Small Scale Industries, introduction of Liberalized Exchange Rate Management System (LERMS), etc.;

(iii) India becoming a signatory of the World Trade Organization. (Of course, India was a signatory to the GATT since 1948);

(iv) Simplification of excise classifications, introduction of VAT and MODVAT, material reduction in maximum marginal rates of IT Act and simplification of rules;

(v) Beginning of disinvestment and divestment process in public sector enterprises (PSEs). The government initiated disinvestment of its stake in many non-strategic PSEs. More importantly, the government divested government monopolies in core sectors like Oil& gas, Power, Coal, Roads, Ports, Civil Aviation, Communication, etc.

(vi) India gained recognition as a major center of information technology (IT) and pharmaceutical research and development center in the world. For the first time, thousands of Indian professionals (Software Engineers & developers, Bankers, doctors and Managers) started working and travelling across the globe, unlike decades when Indian worker mostly got low paid blue-collar jobs.

(vii) Strategically, India was recognized as a country having a nuclear deterrent. Significant advances were made in development of missile and space research technologies.

All these developments gain higher importance when we consider that this was the era of significant political instability (minority governments 1989-1995, and then three general elections during 1995-1998) and financial constraints (Balance of Payment crisis in early 1990s, economic sanctions post nuclear tests in 1998, massive stock market scams, financial sector crisis and bankruptcy of multiple development financial institutions like UTI, IDBI, ICICI, IFCI).

More notably, till 1990 Indian and Chinese economies were mostly at par. We could even say that India had a marginal edge over China as it had wider global acceptance due to its democratic traditions. China also started its economic transformation around the same time. In 35 years, the Chinese economy has sprinted miles ahead of the Indian economy. No one, not even Indian politicians, is claiming that we are even in the race to bridge this gap in the foreseeable future.

This morning, I am writing this after reading about 20 equity research reports. All these reports, without even a single exception, have expressed worries about inflation and CAD due to the spike in crude oil prices in the global markets. It felt like déjà vu.

Back in 1990-91, as the Gulf War broke out, crude prices spiked and sparked the same anxiety. Three decades on, monsoon dependency and crude oil shocks remain headline risks for the Indian economy. Three decades later, nothing seems to have really changed - we’re still haunted by monsoon uncertainties and oil shocks.

Despite a decade of brave reforms and a globalized capital base, India’s macro vulnerabilities remain eerily similar. Our reforms deepened markets and broadened participation, but left key structural risks unaddressed.

So, the question we need to ask is “where did we lose our way in the past couple of decades?”

To me, India’s growth story remains compelling, but ignoring its macro vulnerabilities is difficult. The past teaches us resilience but the future demands vigilance.

Thursday, December 12, 2024

Living on hope

The Reserve Bank of India (RBI) recently released the results of its latest forward-looking surveys (November 2024 Round). Based on the feedback received from the respondents the survey results provide important insights with respect to consumer confidence, inflationary expectations and economic growth expectations.

Consumer confidence – Present tense, hopes high for future

The survey collects current perceptions (vis-à-vis a year ago) and one year ahead expectations of households on general economic situation, employment scenario, overall price situation, own income and spending across 19 major cities.

As per the survey results, Consumer confidence for the current period declined marginally owing to weaker sentiments across the survey parameters except household spending. The current situation index (CSI) moderated to 94 in November 2024 from 94.7 two months ago. (A value below 100 indicates a state of pessimism)

However, for the year ahead, consumer confidence remained elevated, improving 50bps from the previous round of Surveys. Households displayed somewhat higher optimism on one year ahead outlook for major economic parameters, except prices. The future expectations index (FEI) stood at 121.9 in November 2024 (121.4 in the previous survey round).

The respondents’ sentiments towards current earning moderated marginally, they displayed high optimism on future income which was consistent with their surmise on employment conditions. Households anticipated higher spending over one year horizon on the back of higher essential as well as non-essential spending.

Household inflationary expectations rise

Households’ perception of current inflation rose by 30bps to 8.4%t, as compared to the previous survey round. Inflation expectation for three months horizon moderated marginally by 10 bps to 9.1 per cent, whereas it inched up by 10 bps to 10.1 per cent for one year ahead period.

Compared to the September 2024 round of the survey, a somewhat larger share of respondents expects the year ahead price and inflation to increase, mainly due to higher pressures from food items and housing related expenses. One year ahead, the price expectation of households is closely aligned with food prices and housing related expenses.

Male respondents expected relatively higher inflation in one to three months, as well as one year ahead, as compared to the female respondents.

Forecast on macroeconomic indicators – growth scaled down marginally

GDP: Real gross domestic product (GDP) is expected to grow by 6.8% in 2024-25 and 6.6% in 2025-26. Forecasters have assigned the highest probability to real GDP growth in the range 6.5-6.9% for both the years 2024-25 and 2025-26.

Annual growth in real private final consumption expenditure (PFCE) and real gross fixed capital formation (GFCF) for 2024-25 are expected at 6.2% and 7.9% (revised down), respectively. Real gross value added (GVA) growth projection has been revised down marginally to 6.7% for 2024-25 and kept unchanged at 6.4 per cent for 2025-26.

Inflation: Annual headline inflation, based on consumer price index (CPI), is expected to be higher at 4.8% for FY25 and 4.3% for FY26.

External sector: Merchandise exports and imports are projected to grow at a slower rate of 2.4% and 4.6% respectively in FY25 and recover to 5.5% and 6% respectively in FY26, in US dollar terms. Current account deficit (CAD) is expected at 1.0% (of nominal GDP) during both FY25 and FY26.

Wednesday, September 25, 2024

State of the economy

The Reserve Bank of India (RBI) has issued its latest assessment of the state of the economy. The paper notes the marked slowdown in the global economy; it exudes confidence in the sustainability of 6.7%-7% GDP growth in India. In particular, the assessment sounds buoyant on manufacturing, and household consumption, while taking cognizance of resilience in the services sector. The inflation is forecasted to stay close to the lower bound of the RBI tolerance limit (4-6%).

Global economy slowing

The RBI paper highlights some areas of concern for the global economy. In RBI’s assessment global growth has lost some speed in the first half of 2024 relative to the preceding semester, and momentum has slackened further in the third quarter.

The paper notes, “All around, indicators point increasingly to slowing global economic activity, more so on the eastern shores of the Atlantic, which vindicated the ECB’s September rate cut to secure a soft landing. In the US, the now famous remark – “The time has come for policy to adjust” – has built up expectations that the economy is gaining prominence in monetary policy discourse. In China, even though consumer inflation has picked up modestly due to supply constraints related to extreme weather, weakening producer prices are fueling concerns that deflationary forces are taking root. A rising number of manufacturing industries face lacklustre demand alongside a deep property market downturn now into its third year.” In particular—

Job growth is getting softer than initially anticipated as labour markets continue to slow down, unemployment rates are ticking up and wage growth is easing, although historically high immigration is providing some offset. Consumer confidence surveys show a deterioration in sentiment about jobs.

Equity prices are still stretched but the crash in Nvidia’s stock in early September wiped out about US$ 300 billion in market value, hinting that the artificial intelligence (AI) overhype may be tapering off and expectations are catching up with reality.

Parched returns are drying up the venture capital ecosystem. Record volumes of corporate debt are being issued to head off the volatility triggered by worsening macroeconomic data, and to benefit from falling borrowing and refinancing costs.

OPEC plus has decided to delay a planned output increase as crude prices slumped below US$ 70 per barrel briefly on September 10, but it still plans to revive 2.2 million barrels per day of idle supplies over the course of 2025. Meanwhile, non-OPEC supplies are rising faster, and as the International Energy Agency warns in its September 2024 report, global oil demand is slowing sharply – electric vehicles are already displacing 1.8 million barrels of oil every day – and this is fuelling the sell-off in oil markets. In metal markets, the copper-gold price ratio is closing on to 4 – a rising ratio indicates higher industrial demand and hence a positive growth outlook.

Although upside pressures have likely been seen off, the pace of disinflation remains sluggish, provoking caution among monetary policy authorities about the pace of easing. In fact, the Governing Council of the ECB noted in its September meeting that inflation is expected to rise again in the latter part of this year, partly because previous sharp falls in energy prices will drop out of the annual rates.

Defying gravity, global merchandise trade volume continued to recover in the third quarter of 2024, according to the latest World Trade Organization (WTO) Goods Trade Barometer, amidst rising geopolitical tensions, ongoing regional conflicts, shifting monetary policy in advanced economies (AEs) and weakening export orders. Barring the sub-par performance of electronics, other components of global trade such as automotive products, container shipping and air freight are all firmly above trend, but new export orders are turning down, and raw materials have declined – causes for concern going forward.

EMEs are building up a growth rate lead over AEs to levels not seen in 15 years. Projections suggest that the proportion of EMEs other than China in which per capita GDP is likely to rise faster than the US is on course to surge from 48 per cent over the past five years to 88 per cent in the next five years.

In the recent period, the US dollar has weakened; historically, this has led to greater capital flows to emerging markets.

The global supply chain pressures index (GSCPI) increased in August 2024, rising above its historical average for the first time since November 2023. Geopolitical risks remained high due to continued tensions in the Middle East, albeit with a sequential moderation in August 2024. Supply disruptions have kept container shipping costs elevated, although they recorded some moderation during August-September 2024 from the peak levels recorded in July.

Domestic economy

The RBI sounds quite sanguine about the domestic economic growth, regardless of the soft 1QFY25 data. The paper cautions, “more needs to be read into the slowing of India’s GDP in Q1:2024-25 than just disappointment.” It points out that “The seasonally adjusted momentum of Q1 GDP was strong. Gross value added (GVA) growth actually rose sequentially in Q1, but the increase in subsidies – 3.6 per cent by the Union government and 26 per cent by the states – offset the gains from showing up in GDP growth.”

Household consumption is poised to grow faster in Q2 as headline inflation eases, with a revival of rural demand already taking hold.

The widening trade deficit and a spurt in overseas travel by Indians is likely to swing the current account balance from a small surplus in January-March 2024 to a deficit of 1-1.2 per cent of GDP in the first half of 2024-25. Capital flows in the form of portfolio debt flows, net FDI and non-resident deposits are providing comfortable financing.

Merger and acquisitions deals have been on the decline in the Asia-Pacific region in 2024, but India has emerged as a bright spot with an increase in volumes.

Agriculture suffered in Q1:2024-25 as India experienced the highest number of heatwave days in the summer of 2024, surpassing the previous high in 2010.

The underperformance of agriculture in Q1 was compensated for by a buoyant manufacturing sector and resilient services.

Global funds have been investing heavily in the Indian debt market for the fifth month in a row since May 2024. On the other hand, corporate debt issuances remained low during the financial year so far despite easing yields as issuers awaited the US rate cut.

In the credit market, with deposit mobilization becoming a challenge, banks continue to rely heavily on certificates of deposit to meet funding needs so that lagging deposit growth does not constrain credit. Banks are also offering higher interest rates on deposits, with more than two-thirds of term deposits earning 7 per cent and above. The gap between credit and deposit growth is, however, beginning to narrow. Non-banking financial companies are increasingly turning to offshore bonds. Microfinance institutions are facing some asset quality issues, warranting slowing down the pace of loan growth.

Headline CPI inflation came in below the Reserve Bank’s target for the second consecutive month in its August reading. This is a positive development, especially as the index has remained flat between July and August.

Surplus liquidity in the banking system moderated in the latter half of August, driven by build-up of government cash balances due to GST payments. In early September, however, a pickup in government spending led to the return of liquidity to the banking system. Overall, the average daily net absorption under the liquidity adjustment facility (LAF) decreased to ₹1.45 lakh crore during August 16 to September 17, 2024, from ₹1.52 lakh crore during July 16 and August 15, 2024.

Thursday, September 19, 2024

Fed covers ground with a stride, does not look in a rush

Ending the weeks of intense speculation, anticipation and debate last night, the Federal Open Market Committee (FOMC) of the US Federal Reserve started the latest monetary easing cycle with a 50bps fund rate cut. The Fed fund rate range now stands at 4.75-5.00% This is the first Fed rate cut since March 2020 and has come after a fourteen months policy pause.

No panic in the boardroom

Unlike the previous two rate cycles that started with a rather aggressive 50bps rate cut – first October 2008 post the Lehman collapse and second March 2020 post Covid-19 break out – this cut is apparently not a panic cut.

The Fed chairman sounded confident about growth and employment level. He emphasized that the central bank is not in a hurry to ease policy, as he sees no likelihood of an elevated downturn in the economy. He mentioned, “There’s nothing in the SEP (Summary of Economic Projections) that suggests the committee is in a rush to get this done.”

The Chairman categorically advised the markets to not take this 50bps cut as “new pace”. He said, “we’re going to go carefully meeting by meeting, and make our decisions as we go”.

The decision to cut was however not unanimous. In a rare dissent, one member (Michelle Bowman) voted for a 25bps. This could be seen as yet another sign of “no panic” in the Fed board room.

Committed to price stability without pain in labor market

Announcing a victory over inflation, Mr. Powell announced, “The U.S. economy is in good shape. It is growing at a solid pace. Inflation is coming down.”

As per the latest economic data release, the US GDP expanded at 3% annual rate in 2Q2024 with 4.2% unemployment rate (considered near full employment), and inflation at 2.2% in August 2024.

Outlining the latest policy objectives, he commented, “We’re trying to achieve a situation where we restore price stability without the kind of painful increase in unemployment that has come sometimes with disinflation”. Guiding the markets, he emphasized that investors should take the Fed’s 50bps rate cut as a sign of its “strong commitment” toward achieving that goal.

Neutral rate seen close to 3%

The FOMC members see cuts of 25bps each in November and December FOMC meetings; 100bps cut in 2025 and 25bps cut in 2026 – implying that the latest easing cycle may end with the Fed rate range of 2.75-3.00%.

The Fed Chairman also mentioned in the post FOMC press meet that the neutral rate is likely significantly higher than it was on the previous occasions.

Markets ended lower

Markets – equity, bonds and commodities – ended the day with marginal cuts post the Fed announcement; while the USD was marginally stronger. This could be an outcome of either (i) sell on news; or (ii) traders’ disbelief in what Fed says about the strength of the economy.

What now

In my view, this aggressive 50bps cut is more of a correction than an aberration. Perhaps the Fed realized that they are running slightly behind the curve and hence tried to catch up. I do not see it as a panic move and would not like to indulge in “there is more to it than what meets the eye” debate.

Unlike 2008, there is no corporate balance sheet crisis, no risk of global markets freezing, and unlike 2020 there is no shutdown necessitating fiscal and monetary profligacy. It is a normal rate cycle change in response to a normalizing economic cycle. Therefore, expecting a market reaction like 2008 (sharply down) or 2020 (sharply higher) may not be appropriate.

I feel the US markets will adjust to the new policy trajectory in a couple of weeks and move accordingly. The lower rates shall help arrest the decline in the US housing markets and consumer spending. The bond yields may come down and the hedge trade in gold may begin to unwind. The corporate discretionary spend may also normalize as the cost of borrowing eases. This could be a relief for the Indian IT services companies.

For India, I am not sure if the RBI will rush to cut in October meeting, but would not rule it out completely. Financials and commodities are two sectors that need to be watched closely, in my view.

In the next couple of months, the markets in India will be driven by the 2QFY25 earnings. Any disappointment could lead to a decent correction in the markets. For now, I do not see a need to make any change in my investment strategy. (More on this next week)

The major risk to the markets comes from geopolitics now. The situation in the Middle East is worsening by the hour. NATO and CRIK (China, Russia, Iran and North Korea) alliances are hardening their positions, both on trade and war, making the situation explosive. (More on this next week)

Tuesday, September 3, 2024

Waiting for a divine intervention

Last weekend I visited some villages in the Bareilly, Shahjehanpur and Hathras districts of Uttar Pradesh. I had an opportunity to speak with several medium, small and marginal farmers.

Most medium sized farmers had a good standing crop of paddy and sugarcane. Most of them were, however, circumspect about the final yield, in view of the IMD’s forecast of excess rains in September.

Many small and marginal farmers had lost their pulses and vegetable crops due to heavy rains accompanied by strong winds. They were dismayed and worried about their ability to manage the resources to plant Rabi crops, mostly potato and wheat.

Some of them, who had taken advance from the traders, were also worried about the repayment. None of the small and marginal farmers mentioned the terms like crop insurance, bank loan, Kisan credit card, etc. Thankfully, there is an abundance of fodder for their cattle this time.

After a discussion of 10-12hrs with these farmers, NGO workers helping them with farming & other issues, and village leaders I gathered that the inflation debates in Delhi (in the Parliament & outside) and Mumbai (at the RBI and brokerage offices) may not be relevant for these farmers and common men like me, because—

· Policymakers and analysts may be oversimplifying a very complex problem. Food inflation in India maybe influenced by a myriad of factors, e.g., (i) farm input prices, which are also affected by terms of trade, INR exchange rates, availability of subsidy, etc,; (ii) energy inflation as many farmers use electric or diesel pumps to water their farms, and motor vehicles to transport their produce to markets; (iii) farm labor wages, which in turn is also a function of multiple factors like food and energy inflation, availability of MNREGA wages, & other government cash payouts, demand from construction sector, etc.; (iv) weather condition affecting the volume of production; (v) productivity, which depends on the quality of soil and inputs, farming methods used and availability of equipment; (vi) cost of funds borrowed by the farmers, which also depends on access to institutional finance; and (vii) distance from the market, etc.

Bringing down food prices or slowing down food inflation may adversely impact about 60% of the Indian population that depends (directly or indirectly) on agriculture for their livelihood. The solution may therefore lie in enhancing productivity, market access, access to institutional finance, energy efficiency & renewable energy, land reforms and crop rationalization. Someone may argue that all this is already being done. True, there are government programs and policies for all these solutions but execution is seriously lacking.

· Presently, the primary problem for a majority of the Indian household could be “price affordability” rather than “price inflation”. They may need either a substantial rise in their real wages or a material deflation in the prices of their consumption basket to maintain their regular lifestyle.

· Statistical inflation being debated and analyzed by the policymakers and analysts may be entirely different from what a common household or investor faces (more on this later).

Reading minutes of the MPC’s previous few meetings, it appears that the policymakers might be waiting for a divine intervention to change their policy stance, as hardly any effective step has been taken by them to make life of people easier.

Tuesday, May 28, 2024

FOMC stops just short of dropping the “H” word

The minutes of the last meeting (30 April 2024 – 1 May 2024) of the Federal Open Market Committee (FOMC) of the US were released last week. The discussion provides a decent insight into the policymakers’ thought process about the near-term economic outlook and the likely policy direction.

In my view, the most notable part of the FOMC discussion was the mention of a scenario that may warrant further tightening of policy. Though the participants may not have specifically mentioned the term “Rate Hike” it was very close. The minutes read, “Various participants mentioned a willingness to tighten policy further should risks to inflation materialize in a way that such an action became appropriate.” This is perhaps the first time in the past six months that FOMC participants have explicitly mentioned the likelihood of policy tightening.

The FOMC participants noted that data indicated continued strong economic growth. They, therefore, sounded circumspect about the restrictiveness of the current policy stance. They noted some progress on the inflation front, but found the data pointing “to inflation being more persistent than previously expected and to a generally resilient economy”.

The participants noted that the market expectations from the policy has shifted materially in response to the resilient economic growth and persistent inflation. “The policy rate path derived from futures prices implied fewer than two 25 basis point rate cuts by yearend. The modal path based on options prices was quite flat, suggesting at most one such rate cut in 2024.”

Some of the notable points in the FOMC minutes could be listed as follows:

· Model estimates suggested that inflation expectations rose some, but mostly at shorter horizons. Longer-term inflation expectations appeared to remain well anchored. The possibility that geopolitical events could generate commodity price increases, pose an upside risk to inflation. It would take longer than previously anticipated to gain greater confidence that inflation was moving sustainably toward 2 percent.

· The recent monthly data has shown significant increases in components of both goods and services price inflation. The disinflation process would likely take longer than previously thought. Increased efficiencies and technological innovations could raise productivity growth on a sustained basis, which might allow the economy to grow faster without raising inflation

· The dollar strengthened as several foreign central banks were expected to start easing policy before the Federal Reserve.

· The valuations across a range of markets appeared high relative to risk-adjusted cash flows. The assessment of vulnerabilities in asset valuations is raised to elevated.

· Labor demand and supply continued to move into better balance, though the speed of this realignment appeared to have slowed in recent months.

· Foreign GDP growth is estimated to have picked up in the first quarter from its subdued pace in the previous quarter. In Europe, economic activity resumed expanding following modest contractions in several economies amid monetary policy restraint and the repercussions of the 2022 energy shock. Growth stepped up in China, led by strong exports, but property-sector indicators remained weak. Elsewhere in emerging Asia, exports rebounded further from last year’s lows, lifted by robust global demand for high-tech goods.

· The risks around the forecast for economic activity were seen as skewed to the downside on the grounds that more-persistent inflation could result in tighter financial conditions than in the staff’s baseline projection; in addition, deteriorating household financial positions, especially for lower-income households, might prove to be a larger drag on activity than the staff anticipated.

· A range of risks are emanating from the banking sector, including unrealized losses on assets resulting from the rise in longer-term yields, high CRE exposure, significant reliance by some banks on uninsured deposits, cyber threats, or increased financial interconnections among banks.

· Although monetary policy is seen restrictive, many participants were uncertaint about the degree of restrictiveness. They saw this uncertainty as coming from the possibility that high interest rates may be having smaller effects than in the past, that longer-run equilibrium interest rates may be higher than previously thought, or that the level of potential output may be lower than estimated.

My impression from the FOMC discussions is that even though the ‘Rate Hike’ is not mentioned in the minutes; it is clear that the status quo might last longer than anticipated (higher for longer). There is a fair degree of uncertainty over the Fed's next move. Presently the market is forecasting a 25-50 bps cut in the Fed’s target range for bank rate, a 25bps hike in the next 12 months cannot be completely ruled out.

Wednesday, January 10, 2024

Economics vs geopolitics

“Economic efficiency” is one of the fundamental principles of economics. An efficient economy exists when every resource is allocated in the best possible way while minimizing waste and inefficiencies. The objective is to optimize productivity – producing goods and providing services at the minimum possible cost. A state of full efficiency is, of course, a theoretical concept. Nonetheless, by striving for this state economies, enterprises, and households aim to minimize waste and optimize the cost of producing goods and providing services.

The principle of ‘economic efficiency’ is at the core of the globalization of trade and commerce. Countries have their strengths regarding resources (man, material, money etc.), technology, infrastructure, policy framework, etc. Affording countries to produce goods and services according to their strength means optimum utilization of the available resources for the benefit of all the trade partners. However, local political and geopolitical considerations impede the achievement of full economic efficiency.

The globalization of trade and commerce in the past five decades resulted in a shift in the production of goods and services to Asia with abundant human and mineral resources. First Asian tigers and subsequently, China, Vietnam, Taiwan, and India became major producers of goods and services and Western economies took charge of research & development, technology, financial services, and logistics, etc. Even the production of fossil fuels, to support the rising consumption of energy, was outsourced to Middle East Asia, Australia, Africa etc. The trend has arguably contributed to a structural downward shift in global inflation, despite a relatively loose monetary policy regime.

The arrangement has worked well for most of the economies that opened up to participate in the process of globalization. In particular, the past three decades have been an era of overall peace and prosperity. However, logistic challenges and geopolitical developments in the past 3 years are threatening to reverse the trend. The question to examine is whether we are going to witness geopolitics and political ambitions triumph the globalization based on the principle of economic efficiency; or it’s just a passing phase.

Thursday, November 9, 2023

Investment strategy challenge

Wishing all the readers, family, and friends a very Happy Diwali. May the Lord enlighten all of us and relieve everyone from pain and misery.

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The growth is slowing across the world. The engines of global growth - India and China – are also expected to slow down in 2024. Most European countries are flirting with recession. Canada is technically in recession. The US growth is stronger than estimates but not enough to support the

Growth decelerating

As per the latest World Economic Outlook report released by the World Bank, global growth has slowed down to 3% in 2023 from 3.5% recorded in the year 2022. The global economic growth is expected to further decelerate to 2.9% in 2024. The advanced economies have grown by 1.5% in 2023 against 2.6% in 2022. Their growth is likely to further decelerate to 1.4% in 2024. Economic growth in Emerging economies is also not accelerating. These economies are expected to grow at the rate of 4% in 2023 and 2024, against 4.1% in 2022.

Though the likelihood of a hard landing in the US may have receded, the risks to the growth still remain tilted to the downside.

Inflation persisting

The growth slowdown could be largely attributed to the effects of the monetary tightening measures taken since 2022. However, despite the sharp growth deceleration, global inflation is likely to stay above 5% in 2024 also. The World Bank expects global inflation to ease to 6.9% in 2023 and 5.8% in 2024, against 8.7% in 2022. In recent weeks, the inflationary expectations have risen again and could contribute—along with tight labor markets––to core inflation pressures persisting and requiring higher policy rates than expected. More climate and geopolitical shocks could cause additional food and energy price spikes.

Geoeconomic fragmentation – risks rising for emerging economies

The rising geoeconomic fragmentation is seen as a key risk to global growth and financial stability. Intensifying geoeconomic fragmentation could constrain the flow of commodities across markets, causing additional price volatility and complicating the green transition. Amid rising debt service costs, more than half of low-income developing countries are in or at high risk of debt distress.

No room for policy error

Given the still high inflation, unsustainable fiscal conditions and high cost of disinflation, there is little margin for error on the policy front. Central banks need to restore price stability while using policy tools to relieve potential financial stress when needed. effective monetary policy frameworks and communication are vital for anchoring expectations and minimizing the output costs of disinflation. Fiscal policymakers should rebuild budgetary room for maneuver and withdraw untargeted measures while protecting the vulnerable.

However, if we juxtapose these economic realities with the market performance, the dissonance is too stark. Formulating an investment policy that balances the macroeconomic and market realities is extremely challenging under the current circumstances.

I shall share my thoughts on this after the Diwali break. I will post next on 17^th November.

Thursday, September 21, 2023

Fed pauses; keeps the window open for further hikes

The Federal Open Market Committee (FOMC) of the US Federal Reserve (the Fed) decided unanimously to keep the benchmark fund rate in the range of 5.25% - 5.5%; pausing one of the sharpest hike cycles in the past four decades. Beginning in March 2022, the Fed has hiked the benchmark rate 11 times to the highest since 2001.

The latest FOMC decision may be influenced by the recent evidence showing that the hikes already implemented are beginning to impact inflation, despite strong economic outcomes. Notwithstanding, its latest decision to pause, 12 out of 19 FOMC members felt that one more rate hike would be needed in 2023 before the current rate hike cycle ends, as inflation is still running above the Fed’s 2% target. The persistent strength in the economy requires caution as inflation might bounce back again.

In particular, FOMC members sounded cautious about the tight labor market, as wage growth has so far accounted for the bulk of price pressures in the service sector,

Higher for longer

Speaking at the post-meeting press conference, Fed Chairman Jerome Powell, cautioned that "Holding the rate doesn't mean we have reached the stance we seek”. The committee projects the median Federal Funds rate at 5.1% in 2024, higher than its June estimate of 4.6%, suggesting that rates will remain higher for longer than earlier projections.

The FOMC members now see a couple of rate cuts in 2024, against four rate cuts projected previously. For 2025, interest rates are expected to drop to 3.9%, well above the 3.4% previously projected, and fall further to 2.9% in 2026.

Economic growth forecast upgrade

Taking cognizance of the persistent strength in the economy, FOMC upgraded its economic growth forecast for 2023 to 2.1% from the previous 1% rate projected in the June 2023 meeting. The growth forecast for 2024 was also raised to 1.5% from the previous 2.1%.

Yields spike, curve inverted

Post the announcement of the FOMC decision, the US bond yields rose to cycle highs. The benchmark 10-year G-Sec yields ended at 4.395%, while the more sensitive 2yr yields were at 5.17%. The US treasury bond yield curve is now sharply inverted, indicating market expectations of much slower growth, if not full-blown recession in the offing.

Equities correct led by big Tech

The US Equities corrected over 1% from their intraday highs, post the FOMC decision. The fall was led by the growth sectors, especially the big technology companies like Alphabet (-3%), and Meta Platforms (-1%) and Apple (-1%).

Wednesday, August 30, 2023

Sailors caught in the storm – Part 2

Recently released minutes of the meeting of the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) highlighted that the latest policy stance is primarily ‘Wait and Watch”. This stance is driven by the hopes of:

(a) Mother Nature helping a bountiful crop (especially vegetables);

(b) Current rise in inflation being transitory in nature; but MPC is ready to preempt the second-round impact;

(c) Capex (both public and private) sustaining despite positive real rates and diminishing liquidity and continuing to remain broad-based;

(d) Growth in the Indian economy staying resilient enough to withstand the external challenges; and

(e) Government taking adequate steps to mitigate supply-side shocks, while maintaining fiscal discipline, trade balance, and growth stimulus.

Evidently, RBI has no solid basis for making these assumptions.

The monsoon is not only deficient, it is poor both temporally and spatially. Only 42% of districts in the country have received a normal (-19% to +19% of normal rainfall) so far. The remaining districts are either deficient (-20% to -85% of normal rainfall) or have received excessive rainfall (+20% to +156% above normal). Key Kharif states like Easter UP, Bihar, Jharkhand, West Bengal, Maharashtra, and MP are deficient. Whereas, the western states of Rajasthan and Gujarat and the Northern states of Himachal, J&K, and Uttarakhand are in the large excess bracket. Key vegetable producing states like UP, Karnataka, Maharashtra, and West Bengal are highly deficient. Besides, the reservoir levels in the key state have fallen below long-term averages and could have some impact on Rabi crop also. Apparently, assumptions of early relief in vegetable & fruits, dairy, oilseeds, and pulses inflation are mostly based on hope.

The impact of the supply side intervention of the government post MPC meet, e.g., export duties on onions, and rice, etc., and release of onion buffer stock; fiscal support like subsidy on tomatoes, etc., could prove to be short-lived. Tax collections have started to weaken, further impeding the fiscal leverage for stimulating the economy.

Foreign flows have moderated in recent months. The pressure on INR is visible. The imported inflation, especially energy, could be a major challenge. Most global analysts and agencies are forecasting higher energy prices this winter due to depleted strategic reserves, continuing production cuts, and persisting demand.

One of the key drivers of the overall India growth story, viz., private consumption, does not appear to be in very good shape. High inflation and rates may keep the consumption growth subdued for a few more quarters at least. In any case, we are witnessing signs of heating up in personal loans and the housing market.

The other key driver of growth, the private capex, has shown some early signs of revival in the recent quarters. However, positive real rates, cloudy domestic consumption demand, and poor external demand outlook could hinder acceleration in private capex. The government is front-loaded its capex budget in the first half of the fiscal year in view of a busy election schedule in the second half. The assumption of growth acceleration may therefore be misplaced. In fact, the RBI has itself projected a much slower rate of growth for 2HFY24 and 1QFY25.

Recently, banking system liquidity has slipped into negative territory. Besides a hike in effective CRR, the RBI has been ensuring the withdrawal of ‘excess’ liquidity from the system. We may therefore see a hike in lending rates as MCLR for banks rises (even if the RBI stays put on repo rates) as we approach the busy credit season. The credit growth may be impacted due to this.

Tuesday, August 29, 2023

Sailors caught in the storm

I have often seen that when we fail to find solutions to our problems with the help of science and economics, we tend to look towards the heavens and seek to find answers in philosophy. It is not uncommon for businesses, administrators, and policymakers to seek divine intervention when science and economics are not helping to resolve a problem. The global policymakers and administrators seem to have reached such a crossroads one more time, where the conventional practices, accumulated knowledge, and past experiences do not appear to be of much help. Their actions appear driven more by hope than conviction.

The war in Ukraine; the economic slowdown in China; and the monetary policy dilemma in the US and India are some examples of problems where the administrators and policymakers seem to be hoping for divine intervention. I see the recent speech of the US Federal Reserve Chairman Jerome Powell at the Jackson Hole symposium and the minutes of the last meeting of the monetary policy committee of the Reserve Bank of India in this light.

After 16 months of aggressive monetary tightening, the Fed is not confident whether they have done enough; or they have overdone with tightening or they are lagging behind. He reiterated that the policy is restrictive enough to anchor inflationary expectations, but still expressed fears that the high inflation might get entrenched in the economy and may require treatment at the expense of higher unemployment. Chairman Powell indeed sounded more like a sailor trapped in a storm, when he said, “We are navigating by the stars under cloudy skies”.

The situation in the US, as I see it from thirty-five thousand feet above sea level, is as follows:

· The US Federal Reserve has hiked the key policy rates from near zero (0.25%) in March 2022 to 5.5% in August 2023. This is one of the steepest hikes in the past four decades.

· The US financial system faces a serious challenge as MTM losses on the bond portfolios are accelerating; retail delinquencies have started to build up;

· The positive real rates in the US are now 2% or higher. Despite these restrictive rates, the economy is not showing much sign of cooling down. The probability of growth acceleration in the US economy in the next couple of years is therefore remote.

· Inflation continues to persist above 4% against a committed target of 2%. The household savings may therefore continue to shrink at an accelerated pace.

· The mortgage rates are well above 7%, the highest in two decades. Housing affordability is at its worst in history.

· The US government is paying close to US$1trn/year (about 20% of revenue) in interest on its borrowing, which is an unsustainable level.

· The cost of borrowing (and interest burden) for the US government shall continue to rise for a few years at least as the Fed reduces its balance sheet, foreign governments cut on their demand for the US treasuries, and the rating of the US government’s debt face further downgrades. The fiscal pressures thus remain elevated.

· The money supply (M1) in the US at US$19trn is about 4.5x of the pre-Covid levels. It may take years to normalize at the current speed of quantitative tightening (QT) by the Federal Reserve.

·
The “Lower for Longer” narrative has metamorphosed quickly into “Higher for Longer”. However, analysts, economists, and strategists who are in their 30s may have never witnessed a major rate or inflation cycle in their professional careers. Their assessment of peak rates and peak inflation may be suffering from some limitations.

….to continue tomorrow