Inflation Rises, Markets Fall

Friday, again turned out to be a bad day for the markets. Just when the global cues were okay and the markets were showing some signs of recovery, we were hit by another bit of negative news. This time the culprit was the inflation data (wholesale price index), which showed that it is now rising with a growth rate of 7%. Gradually, it has started picking up speed too. The markets went down because it seemed imminent that the RBI would soon have to increase the interest rates to control inflation.

Seen above is the daily chart of Nifty. We can see from that chart that between the period Jan 21st to Mar 7th, the Nifty was in a range of between 4800 and 5550. Finally it broke out of that range on Mar 7th, against all expectations and when a target of 4100 was expected, it went into another small range between 4480 and 5000. In the intermediate term, nothing can be said until this range is broken out of. The short term trend has now again changed to down. Stay away from the markets until the trend emerges clearly. Long positions taken yesterday, if any, may still be held with a stop loss of 4480.

Lately, there has been so much talk about the economics of our country. Talk that our country’s economy is growing and that the GDP of the country which was exhibiting a growth rate of 8.5% to 9% has now reduced to about 7%. Also, the inflation index (wholesale price index) which was floating below 5% for quite sometime has now increased to more than 7%. And talk about whether the interest rates should be decreased to reduce the interest rate differential between America and India. Or whether they should actually be increased to control inflation? But, how many of us really understand what all this talk is about? What really is the GDP, what is inflation, how do interest rates affect inflation/GDP? Do we really understand those things or do we leave it all for ‘Dr. Reddy’ and ‘PC Uncle’ to handle? Well, while ‘PC Uncle’ (Mr. P Chidambaram) and Dr. YV Reddy are much more knowledgeable about these things than we are, we should really be knowledgeable enough to know whether they are managing our country properly or not. Knowledgeable enough to know that what they are doing is best for the country. And knowledgeable enough to know that we are not being taken for a ride.

This post is definitely not written to explain all fundamentals of economics and is most definitely not going to go too deep into everything. It is just a very simple mail to make the readers understand a little bit about these economic matters so that they know what all this talk about GDP, inflation and interest rates really is about. At the end of the post, I’m sure a lot of you would still have a lot of unanswered questions. You can please leave all your questions and comments about this post in the comments section below and I will try and address those queries (with whatever little knowledge that I have).

There is an earlier post which has talked about what GDP really is. In layman’s language, GDP is the sum of the total consumption, investments, government spending and net exports. In simpler words, it measures the financial health of a country. When we say that GDP is showing a growth rate of 8% that means that if the GDP today is a trillion dollars, then next year it would probably be 80 billion dollars more than a trillion or $1.08 trillion. But how does the GDP grow?

When we begin to think of a starting point of an economy, we don’t know where to begin with. It’s all like the chicken and the egg story. But let’s begin anywhere. Let’s say that a country is in a deep recession, companies are not able to make profits, they have to cut down production, lay off people and everything looks bleak. Then the central bank reduces the interest rates. This makes it cheaper for the companies to borrow money. Some of the daring ones borrow more money to increase production. This needs additional workforce. The number of jobs increase, the employees start getting money and their spending (on various items like necessities, wants and luxuries – in that order) increases, which increases the sales of the companies. Additional sales means additional profits, which means more production, more jobs and more spending. And suddenly things are not looking all that bad. There are jobs available, the companies’ profits are rising and there is more consumer spending, all of which contribute towards the increase in GDP. Everything is rosy now.

Everything is rosy now? For how long? With so much money available in hand, the consumers are willing to spend on everything, even on luxuries. And they don’t mind paying a little bit additional for anything since they have additional money available. So, demand increases and supplies are not enough to meet all this demand. So, a simple law of economics comes into force and prices increase. This increase in prices leads to inflation. Inflation cannot be left untackled because soon the prices may start rising exponentially. And inflation is the worst enemy of growth.

The only way to tackle inflation is to reduce the demand, which can only be done by tightening the money supply. And to tighten the money supply, the central bank has to increase the interest rates. An increase in interest rates leads to decreased borrowing, which in turn leads to decreased production, lay offs and decreased consumer spending. That leads to lower sales, lower profits and soon the companies again start making losses.

It all starts off with the GDP growth rate coming down and down and soon there is no growth. The expenditures are more than the incomes and the country starts eating into its reserves. That period when the growth rate becomes negative is called a recession. That is what America is going towards, though unofficially people have started saying that it already is in a recession. All these things don’t happen quickly. A full cycle from a peak to a trough and back to the peak again (or vice versa) usually takes between 4-5 years.

US is moving towards a recession. India is not. India still has a growth rate above of 7%. So the rate of growth has definitely reduced from 9% and above to between 7 to 7.5%. That is not recession. Recession will come when this growth rate keeps decreasing to zero and then becomes less than zero. And that is still a long time away.

Presently, inflation is catching up with India and soon the central bank (RBI) may have to increase the interest rates. That will affect the growth rate but inflation is a bigger enemy of the country than a lower growth rate. Mr. SS Tarapore, a noted economist and a former RBI Deputy Governor, in a recent interview on CNBC mentioned that the inflation index “greatly and grossly understates” the extent of inflation which means that if the inflation index is 7% then at the grassroots level (consumer price index) it is actually much more than that and that it is a ‘sin’ to let the inflation increase because it affects the poorer section of the society more badly. He is of the view that the RBI should increase repo rates by about half a percent in one or two steps and should introduce an incremental cash reserve ratio. He says that the younger economists who argue that the rupee should be allowed to appreciate and the interest rates should be lowered are wrong because doing that would be an “unmitigated disaster”, specially for a country like India which still has a fiscal deficit to deal with. He finally ended the interview by saying that there has to be a trade off of “lower interest rates and higher inflation” with “lower inflation and higher interest rates”. According to him that definitely would cause pain but one has to learn to live with the pain.

I hope, after reading this article, things like GDP, growth rate, inflation, interest rates seem to be a lot simpler. In case you still find any difficulty, please feel free to leave your queries by clicking on comments below.

Happy investing!!!

Update: This article was also published on the business and investing page of Reuters.

Other Posts That May Interest You