The Inflation Rate in India is Running About 12%

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Monday, the Dow dropped 239 points. Oil rose $1.46. Gold remains at $927. And the yield on a 10-year Treasury note is barely above 4%.

It’s that last item that puzzles us.

People are buying Treasuries for safety. Money markets, which hold short-term Treasury bills, are at record levels. We understand why you might want to have money in a money market fund…but where’s the margin of safety in a 10-year note paying less than the rate of consumer price inflation? Even in the money market funds, you’ll lose money when the dollar goes down – whether it goes down against other currencies or against consumer items. And what do you get in exchange for the risk? Not much. The 91-day T-bill rate is only 1.66%.

Currently the inflation rate – according to official statistics – is near 5%. Buying a 10-year note at a full percentage point lower is not a safe investment – it is a speculation, a bet on the direction of rates in the future. If they go…the value of the T-notes goes down.

Lately, that’s begun to look like a reasonable bet.

“Falling prices ease worries about stagflation,” says a headline in the International Herald Tribune . Oil is down about 15% from its peak. Food has fallen a similar amount. Could it be that inflation has topped out? Could it be that the “civil war” between inflation and deflation is finally reaching a conclusion…with deflation the clear winner?

Could be. Then again, it could not be.

“The question for investors is whether the slump in oil and commodity prices will last or is simply a temporary retreat brought on by overstretched increases,” continues the IHT . If the increase in prices won’t last, we can all forget about girding our loins for the fight against inflation. We can simply buy Treasury notes and wait for the current downturn to pass, right?

Maybe. Maybe not.

Inflation is at about two and half times the Fed’s key lending rate. Overseas, many countries are facing much higher rates. Russia has an inflation rate of 14%. China’s rate is over 7%. Inflation in India is running about 12%. And Dubai has inflation at 22%. Dubai, by the way, is a bubble. It has only .02% of the globe’s population. But it is home to 10% of the world’s construction cranes and seems hell-bent to prove to the world that there are bigger fools than Americans – as if that needed proving. It now has the world’s only 7-star hotel…and the world’s tallest building too. In the harbor, it’s building a series of artificial islands in the shape of a map of the world.

The gods must be watching…and getting ready to teach Dubai a lesson. What would it take to kick Dubai in the pants? A lower oil price…

For the last few weeks, oil has been going down…and the news has been overwhelmingly deflationary. The S&P is down 14% for the year. The credit crunch continues to pinch businesses and investors. This morning, we got news that Merrill Lynch announced $5.7 billion in write-downs. Wall Street will hand out an estimated $10 billion less in bonuses this year. Mortgage-backed securities are selling at only one-fifth the rate of a year ago. And the IMF says there is “no end in sight for the credit crisis.”

Now, it’s beginning to hit the wealthy, too, says the Financial Times. Prime mortgage delinquency rates are increasing. So are late payments among the best credit card customers. AMEX, which targets good-quality borrowers, saw its earnings fall 37% in the second quarter.

Meanwhile, investors are selling stocks short at record levels. The pros think stocks are a bad bet. This puts the stock market under a lot of tension. A rally to the upside can be explosive, as the shorts need to buy in order to cover their positions. On the other hand, the pros may be right; deflation is a big threat to stocks. The amateurs may be right too – they’re moving to cash and bonds.

Cash is probably a good move. You’re protected against defaults and write-downs. And you can take cover if inflation gets worse. Moving to bonds is another matter. They are a leveraged bet against inflation. And yes, for all we know inflation is dead forever. But we wouldn’t want to bet on it.

Bill Bonner
for The Daily Reckoning Australia

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
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Comments

  1. RBI is increasing inflation instead of controlling it!
    The action taken by RBI to control inflation is not admirable. The tool of interest is spoiling our nation. Every time attempt to control inflation through altering interest rate is easy for RBI, but disastrous for the economy. RBI should revisit the decisions taken up to control inflation. Interest can affect liquidity and control inflation for time being by curbing the demands but cannot control ultimate inflation as the higher deposits at banks will yield higher interest expended over those deposits which in turn enhance the purchasing power of the depositors with no increase in real GDP. Thus this practice by RBI to control inflation itself leads to inflation.
    The annual interest income by banks is over 5% of GDP at Market Prices. It means the prices of commodities and services produced with help of bank credits would be increased by at least 5%. Interest income by banks thus increases the price levels by minimum 5%. Moreover the interest expended by banks over deposits is over 3% of GDP at Market Prices. It means the deposits buying capacity would be increased due to interest while GDP remaining unaffected; the price level would further increase by at least 3%. So due to interest earned by banks and expended over deposits, the price level increases by over 8% per annum. In this situation if interest rate is further increased, the inflation will not be controlled, rather stagflation will increase. Already we can see that our total final consumption expenditure as % of GDP at market prices is declining from 67.8% in 2005-06 to 65.5% by 2007-08. This decline along with inflation cannot be controlled by increase in interest rate. On the contrary, we need stimulator for productivity and sales in the real market, which requires reduction in interest rate.
    The practice of RBI to control inflation by interest rate is disastrous for Indian economy and should be questioned. The role of interest to control liquidity is not questionable but its impact over income level of depositors, borrowers and the price level should be re-considered and it is important that RBI should review these impacts. It should be noted that if banks expend worth 3% of GDP at market prices as interest to deposits, the liquidity automatically increases without real change in GDP, thus causing inflation.
    We should consider and find long term solution for instability in financial and real markets. If RBI or financial sector regulators wish, Islamic ethics on Banking and Finance may guide us promote ant inflationary, stable and equitable system for economic growth. Islamic Banking is the most needed mechanism at this time which could solve the problems. The fear that Islamic banking would not benefit the corporate or nationalized bankers is just based on prejudice only. The corporate and national bankers along with stock market would be in better position after introduction of Islamic Banking. Islamic Banking would also increase D mat account and capitalization at stock market. Hopefully AMU with attempt to promote education about Islamic Banking and Finance may improve our understanding about the alternative banking and financial mechanism. Islam advocates for anti inflationary and stable economic system with socio-economic justice as an objective of governance.
    Syed Zahid Ahmad

    Reply
  2. An Islamic bank that doesn’t charge interest ?
    I read about their inception into the U.K banking market and offering mortgages. All it seemed to me was a re-wording of terms. The customer still payed house price plus to the bank at a rate equal to standard interest repayments. Sorry Syed, more education (and convincing) for me please.

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  3. Syed. I’m a bit rusty on some of the principles here but I’ll do some more digging. Excess money printing, risking energy, resource and food prices (externally driven) leads to inflation which leads to the neccessity for exorbitently high interest rates which (in an Indian context) leads to a high impact on the poor and the the lower middle classes. And as credit dries up, the less wealthy are tempted to the borrow from the type of loan sharks that were observed (and proscribed) by the Prophet.

    My understanding is that classical Islamic banking principles included something of a call for the gold (and precious metal) standard as a “weight” of value. At this time I understand they were less concerned about small interest charges applied to fiat currency. The emphasis was on purchasing power value rather that the nominal purchasing power of fiat currency.

    I have to say that the “equity” banking principles of some Islamic banks can also be “just” or “unjust”.

    For the record, I like what the Grameen bank does in Bangladesh (providing mirco finance to the poor on “just” terms.

    Coffee Addict
    August 1, 2008
    Reply
  4. I wish to add some more contents as desired by Joe to convince him how RBI or intrerest based banking system is inflation indian Economy. This interest based system has already spoiled the most advanced nations like USA and UK; and now we are marching towrads desaster. Just read my edited version of what I wrote earlier.

    RBI is inflating the Indian economy
    Syed Zahid Ahmad

    The present trend of recession in US and prevailed uncertainty in petroleum nations had provided an opportunity for India to pull capital resources from US and Gulf countries, but the practical approach of RBI has converted the opportunities into challenges as the liquidity and inflation is certainly not under control of the RBI who is attempting to freeze the liquidity by increasing the interest rate and cost of credits. Interest is a factor for liquidity and credit, but all cares should be taken up while we handle this instrument because if liquidity and credits influences inflation, are also necessary for growth and development. Increased cost of credits not only increases the cost of output, but also creates shortage of supply. This increases the prices levels further up. However the depositor gets higher rate of interest over their deposits and this inflates their purchasing power, thus boosts inflation. FICCI and the corporate sector have already disagreed with RBI recent announcement to increase the rate of interest.

    With recent trend of increased capital inflow into India the aggregate deposits by Scheduled Commercial Banks (SCBs) has increased from 80.7% in 2005-06 (Rs. 21,09,049 crores) to 102% (Rs. 31,96,939 crores) of GDP at factor cost by 2007-08. With increased deposits, the bank credits has also increased from Rs. 15,07,077 crores in 2005-06 to Rs. 23,61,914 crores by 2007-08 reflecting 75.6% of GDP at factor cost in 2007-08 as credit against 57.7% in 2005-06. This indeed is a situation, where our economists, financial sector regulators and bankers need to review the policy and practices adopted by RBI as we take interest as a major tool to control liquidity but we hardly evaluate the far reaching consequences of interest in our economic process.

    Our net real term GDP growth rate (= GDP growth rate at factor cost – rate of inflation) has considerably declined from 5.2% in 2005-06 to 2.9% by 2006-07 and fell down to1.6% by 2007-08. As the interest increases the cost of credit and output, even the GDP value is inflated through interest. Thus the higher GDP growth rate like 9% just reflects 1.6% real term GDP growth rate if inflation rate is 7.4%. The liquidity theory of J. M. Keynes is failed here to guide RBI optimize these opportunities. The practical approach of RBI to curb the rate of inflation by increasing the rate of interest may not control inflation and might lead towards stagflation as the prices are continue to increase along with purchasing power of the depositors, but the expenditure, investment and net GDP growth rate is falling due to costlier credit and interest based deposit schemes.

    By increasing the rate of interest, liquidity might be controlled for shorter period, but with increased cost of credit, the GDP value will increase that leads to inflation. Interestingly the interest income to SCBs was Rs. 1,85,384.9 crores in 2005-06 which increased to Rs. 2,37,271.14 crores by 2006-07. It means by 2006-07 total interest income to SCBs was 7.1% of GDP at factor cost. It simply means that the interest income to SCBs has inflated the value of GDP at factor cost by 7.1%.

    With increase in rate of interest, the aggregate deposits might increase and SCBs may need to pays more interest over increased deposits. Total Interest expended by SCBs over deposits was Rs. 89,742 crores in 2005-06 which increased to Rs. 1,20,261.08 crores by 2006-07 showing a net annual increase of 34%. This growth is inflationary as it increases the buying capacity of the depositors. By 2006-07, the interest expended over deposits was around 4.20% of GDP at factor cost.

    If we add the interest income of SCBs to interest expended over deposits, it stands for around 12.5% of GDP at factor cost and 8.6% of GDP at market prices in 2006-07. Considering the impact of interest on inflation, we may need to add interest income of SCBs through investments / commercial credits with interest expended by SCBs over deposits. This amounts to approximately 9% of GDP at factor cost and 5% of GDP at market prices in the year 2006-07 while annual rate of inflation was 6.7%. It reflects that basically inflation is a result of interest charged on credits expanded by SCBs and interest expended over deposits. The interest charged by SCBs increases the cost of GDP and the price levels, while the interest paid by SCBs over deposits increases the purchasing power of the depositors. Both ways the interest is increasing the price level and causing inflation. Since RBI regulates the banking business in India, by increasing rate of interest it is increasing the inflation and decreasing the real term growth rates.

    Further to note that RBI is increasing the rate of interest for over one year to control the inflation which ultimately increasing the cost of GDP showing higher GDP value and increasing inflation instead of controlling it. Our total final consumption expenditure as % of GDP at market prices is already declining from 67.8% in 2005-06 to 65.5% by 2007-08. This decline along with inflation cannot be controlled by increase in interest rate. This economic tendency may leads to stagflation which is more dangerous for economic stability and growth. RBI should review its policies and practices to monitor liquidity, credit and inflation, if we have to combat inflation and attain desirable growth rate.

    Often it is argued that inflation devaluates the money and interest over deposits compensates it’s money value, but this argument is missing to note the cruel problem of inflation which arises due to interest and could worse of with more interest over deposits. Islamic economic ethics suggests mechanisms for stable and anti inflationary monetary system which should be adopted by RBI to make our monetary system more stable and anti inflationary. Hope the RBI will consider these ethics as measure to combat inflation and stagflation. Islamic Banking principles and practices will not only increase the equity deposits and finances but also promote capitalization and investments. It will help increase employment and business opportunities which are must for inclusive and foster growth of India at a time when world is eying upon Indian economy for making more investments. Otherwise consistent approach of RBI to control inflation through interest rate may let the UPA government face cruel failures in capitalizing the investment and growth opportunities with worst off inflation and stagflation.

    Wish all the best for Indian economy, the general Indians, RBI and the UPA government.

    Reply
  5. I wish to withdraw the follwoing words from my comemnts.
    Our net real term GDP growth rate (= GDP growth rate at factor cost – rate of inflation) has considerably declined from 5.2% in 2005-06 to 2.9% by 2006-07 and fell down to1.6% by 2007-08. As the interest increases the cost of credit and output, even the GDP value is inflated through interest. Thus the higher GDP growth rate like 9% just reflects 1.6% real term GDP growth rate if inflation rate is 7.4%.

    Reply

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