The Economics Nobel for 2024 underlines the connection between wealth of nations and democracy: Indian Express 14th October 2024

We are all aware of the fact that there is a rather large gap between rich and poor countries. The income gap between these two sets is persistent, and while the poorest countries have become richer, they are not catching up with the richest. Some part of this inequality is historical, but there is strong reason to believe that institutional differences in countries can explain this difference. The developed world has a common thread in the form of political and economic structures, and probably mindsets too. This is the theory espoused by three economists, Daron Acemoglu, Simon Johnson and James Robinson, who have been accorded this year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.

What exactly do they mean by institutions? It is a gamut of political and economic edifices which drive the growth agenda of a country. Simply put, the regime can be inclusive, which is best exemplified by the West which is also largely democratic. This would mean a strong legal system where rules are defined, with an adjudication system in place. There are transparent laws relating to doing business, covering taxes, trade and commerce etc. This provides the contours for doing business.

Alternatively, it can be exploitative as can be seen in autocratic regimes, such as in some parts of Africa. Quite clearly, societies with poor rule of law and institutions that exploit the population do not generate growth or change for the better. When multilateral institutions keep harping on economic reforms, this is what they are talking about.

The 2024 Nobel Laureates do trace their theory to colonialism where they link the quality of institutions to the number of settlers in colonies post-independence. In some places, the aim of the colonists was to exploit the indigenous population and extract resources for their own benefit. In others, the colonists formed inclusive political and economic systems for the long-term benefit of European migrants. This varied across Europe and Asia and Africa. Where colonists remained and settled due to lower mortality, there was evidence of creation of institutions which worked well. They do not justify colonialism, which was exploitative, but do find this positive correlation in places where the colonists became settlers and contributed to this development.

The two main takeaways from their body of work is the importance of a democratic set up and the creation of the right institutions that foster investment. Democracies definitely work better, as there are free elections and while different parties may have varied motivations, one needs to perform in order to get back to power. Hence institutions would necessarily have to be built. Protection of private property is such an institution which comes automatically if there is a strong judicial system. Similarly, various policies that support the growth process would be part of the system.

A question which would come to mind is how China has managed to create one of the largest economies with the latest state-of-the-art infrastructure and production processes. The political system is autocratic for all practical purposes, but has delivered well. Here, the counter argument can be that while the economy is large and competes well with other developed nations, there is immense inequality within the country. Therefore, such guided growth, where the government owns and controls a large part of the means of production, does not bring about an optimal solution in terms of equality.

Singapore can be another contrarian example which is not democratic but has strong institutions. It can be considered an outlier for sure. There are also some of India’s neighbouring countries which are ostensibly democratic but tend to get oligarchic, which has impeded development.

Let us look internally now. The government has focused a lot on the ease of doing business which has been achieved by creating the appropriate institutional structure through a series of reforms in every sector. Providing access to infrastructure, land laws, dispute resolution, strong financial systems etc. are all part of the institutional set up that is required to keep growth ticking. This has been vindicated in our context in the last 10 years or so where India has become the fastest-growing economy though, admittedly, there is a long way to go in becoming a developed economy.

Therefore, while the Laureates do not provide specific solutions, a takeaway can be that unless there are democratic regimes which foster the building of strong institutions, growth across countries will remain lopsided.

How Should Households View The Credit Policy? Free Press Journal: 14th October 2024

 As a layman what is one to make of the credit policy? Credit policies are all about deciding on the repo rate which is the benchmark used as part of the toolkit for ensuring macro-economic stability by the central bank. The repo rate, which is nothing but the rate at which the RBI lends to banks on an overnight basis, is the anchor rate. It is just like the Fed rate which is similar in scope. What these anchor rates do is to guide the direction of movement in all other interest rates in the financial system.

As far as banks are concerned the repo rate becomes the anchor to decide on all other interest rates concerning their deposits and lending rates. The lending rates of banks are driven by two sets of factors. The first is what are called external benchmark lending rates where the interest rate is fixed to a benchmark which is normally the repo rate. It could also be the yield on a security or Treasury bill. Therefore any change in the repo rate would automatically tend to move the lending rate for all banks for loans that are tied to this formula. By statute all retail loans and those to MSMEs are linked to this benchmark.

The second is what is called the MCLR which is the marginal cost lending rate that is a formula-based rate. Here the lending rate is based on the marginal cost of funds which is primarily the deposit cost with other variables being included. This is the minimum rate at which anyone can borrow from a bank and normally there is a spread over the MCLR. Therefore it could be in the range of 50-300 bps and can stretch higher given the risk profile of the customer.

Intuitively it can be seen that what matters here is the deposit rate which is again linked somewhere to the repo rate. The credit policy was eagerly awaited this time because conditions looked seemingly appropriate for expecting some action on the repo rate given that the last two inflation numbers for July and August are less than 4%. The RBI has decided not to change the repo rate which will remain at 6.5%. Therefore, there is no policy push to alter the lending rates as of now.

However, after a long hiatus the stance has been changed to neutral. The stance is something which has been debated for quite some time now. It has been kept as ‘withdrawal of accommodation’ ever since the Ukraine war started. It has been interpreted as a position taken when the RBI is waiting for all past actions on repo rate — the increase by 250 bps invoked since 2022, to be transmitted to the deposit and lending rates.

A ‘neutral’ stance can be taken to be interpreted as the central bank being comfortable with the present state of the system where transmission of interest rates is more or less complete and there is reason to look at rolling back rates when the time is opportune. Here, the policy actually blows hot and cold. There is a lot of caution being expressed over the future course of inflation. The high base effects kept inflation low in July and August and the expectation is that inflation will cross 5% in September. Further the forecast for inflation for Q3 of the year is 4.8% which is much higher than what was witnessed in the first two quarters. This gives a sense of caution that a rate cut cannot be in the offing any time soon.

The RBI has highlighted three factors which can be influencing inflation in times to come. The first is the impact of climate which has manifested in extreme heat and rains in different parts of the country. The potential to affect agricultural output is high, and this is already seen for tomatoes and onions. The second is the geo-political situation which is becoming unstable ever since the Israel issue has resurfaced with Iran getting involved. The potential impact on crude prices as well as logistics costs is sharp and cannot be conjectured at present. Last, there has been a tendency for global commodity prices to rise which will feed into the costs of manufactured goods and increase core inflation.

What does all this mean? It appears that the RBI believes that the worst of high inflation is over. But there is some uncertainty on the durability of the present low inflation and therefore there will be a wait and watch approach. The fact that the stance has been changed to neutral is indicative that a rate cut would be on the horizon, as a stance change prepares the system for a rate change which can be only in the downward direction.

Therefore, one can assume that the era of ‘peak interest rates’ may have ended. Therefore from the point of view of borrowers the picture is clear. The lending rates will only come down though the timing is hard to guess. But from the point of view of deposit holders, it may not be very clear. While deposit rates in general are unlikely to increase across all banks and tenures, the downward movement would also not be generalised. This is so as liquidity conditions vary across banks. While system wide liquidity is comfortable, individual banks are using other means of raising funds including raising deposit rates across specific tenures. Hence it is still possible for certain banks to offer higher rates on some deposits.

In a way it can be said that we may be starting on the cycle of lower rates in future. Going by the inflation forecasts of the RBI and the current geo-political situation, a rate cut is possible earliest in February 2025. While this would be good news for borrowers, it should also be mentioned that in this particular cycle of lower rates, the repo rate cuts could sum to 50 bps as 6% repo rate has been the average over the years. Anything lower could at best be temporary, as inflation would always be a variable that would be hard to keep low for all time.

RBI policy: Prelude to future rate cuts? Inflation numbers hold the key: Business Standard 9th October 2024

 The major takeaway from the credit policy is the change in stance, as it was unexpected. The fact that this was unanimous points to a common view taken by all the six members. This is important because it is largely assumed that a change in stance to ‘neutral’ is a prelude to a rate cut possibility in the future policies. This follows from the view that changing both the repo rate and the stance at the same time is not appropriate, as the power of the stance gets diluted when they are done in unison.  

The change in stance is based on the premise that the growth-inflation matrix is well balanced and conditions are favourable for attaining the goal of durable low inflation in the near future. This raises the issue of whether a repo rate cut is possible in December, as the stance has been changed in this policy.

Going by the forecasts made by the Reserve Bank of India (RBI) on inflation for the balance quarters, there will be an uptick to 4.8 per cent in the third quarter (Q3), which will be the October-December period. It is subsequently supposed to come down in Q4 to 4.2 per cent, which is a signal for assuming durable low inflation. Therefore, a cut in repo rate in the December policy looks unlikely and will have to be pushed forward to February 2025, unless the inflation numbers surprise significantly on the downside in the next couple of months. 

Inflation risks

The policy remains open-ended on the future possibility of rate cut, which sounds reasonable given that the future course of inflation is hard to gauge. The policy highlights three possible risks for inflation. The first is weather changes that can affect food inflation. The monsoon has not yet withdrawn fully, and any possibility of heavy rains can affect harvests. 

Second, the geo political situation is tenuous with the threat of oil prices going up again. While this has not happened when the Israel conflict started, the entry of Iran can change this direction. Third, other commodity prices such as those of metals have been going up, which can add to core inflation. Here the China factor will have a role to play. 

The policy has presented a balanced view of risks and signaled that while it does feel that conditions would be improving on the inflation front, one cannot be too sure. Therefore, the change in stance to neutral echoes that sentiment. There has been no change in the GDP growth forecast, which means that there is no concern on this variable. This has been supported by strong growth in both consumption and investment, which is expected to continue. 

It is hence indicative of the fact that the present interest rate regime does not militate against growth.  With inflation moving down and a good kharif harvest, chances of rural and urban consumption improving looks likely.  

The market reaction would need to be seen. While bank deposit and lending rates would be driven more by liquidity conditions of individual banks, bond yields should move down further. So far they have been influenced more by decisions taken by other central banks as well as liquidity situations. A further downward movement can be expected that will help the government in particular as borrowing costs come down. 

The change in stance is the first alteration made by the MPC ever since the Ukraine war when rates and stance were changed. This does indicate a return to equilibrium state for the economy in the coming months.

Food inflation has strong linkages with other parts of the price index; keeping interest rates high amid high food inflation helps prevent excess demand pressures: Financial Express 8th October 2024

 The economist Milton Friedman had said that inflation is always and everywhere a monetary phenomenon. That is how monetary policy came to the forefront with inflation targeting being the result. An issue which has come up particularly in India is that if inflation is being driven by food products over which monetary policy has no control, are we barking up the wrong tree? As a corollary, some arguments suggest that the share of food in the index should come down or that the central bank should be targeting core inflation which excludes food and fuel. These issues are prima facie pertinent but deserve further probing.

The answer is not straightforward even when one talks of food inflation. While overtly it does seem that supply shocks lead to higher prices there is a demand factor also at play. For example, demand for coarse cereals has been rising over time with the society being driven by health motivations. This has increased the prices of the products. The same holds for cereals where value added products are driven by demand conditions and often not related to supply-side factors. Besides with an open-ended procurement programme run by the Food Corporation of India a lot of grain gets diverted, leaving less for the market in the face of rising demand. At times, such diversion leads to excess demand in markets, which pushes up prices.

Higher incomes make people move to higher-value products, which play in the background. This is but natural. The proliferation of catering, hospitality, and travel businesses has added to the demand of edible oils. A similar example is pulses (especially chana) whose prices rise during festivals due to exceptional demand.

Further, leverage is used for the purchase of goods at supermarkets by even lower income groups. Personal loans have grown at a smart rate across all segments where interest charged has a bearing on purchases. Thus, there is merit in the link between interest rates and demand for food. The problem comes to the fore when there are supply shortages and sharper price increases. Interestingly, even the “core inflation” products do not always witness price rise due to demand factors alone. The increase in, say, telecom prices has nothing to do with demand which remains inelastic once it is a habit. Similarly, when hospitals or educational institutions increase fees, it is not due to demand but the “cost factor”. The cost will include staff salary as well as cost of other inputs going into the service. The same holds true for consumer products, where higher input costs are not driven by demand but global and domestic factors that feed into the final price.

Hence it can be argued that price changes for non-food products are also driven by supply. Further, housing price included in the index is linked to the house rent allowance of government officials, which too is a periodic change and not a demand-side factor though high demand increases housing rent in the real world. It can be countered that with the boom in housing the supply of tenements for rent would always be increasing and often the movements in rent are sluggish.

Therefore, it is hard to distinguish between price increases due to pure demand or supply factors. Both are at play and separating the two forces on the assumption that product (or service) prices are driven exclusively by one can lead to erroneous conclusions. Today, retail credit is the leading segment which involves households. Higher interest rates do keep a check on spending based on leverage as budgets are realigned. Hence even if, for the sake of argument, it is assumed that the food price shock is purely due to supply factors, interest rates have a bearing on household borrowing and hence spending, making policy very relevant.

The problem with food inflation is that when it is high, it feeds into inflationary expectations which then spreads to core inflation and over time becomes generalised. This happens in two ways. One, when there is an upward adjustment of incomes, including wages, which in turn trigger demand pull forces for other non-food products. The Mahatma Gandhi National Rural Employment Guarantee Act wage, which is a benchmark for wage setting in other sectors, gets adjusted with inflation every year and hence automatically increases incomes in other professions. Second, there is a tendency for producers of manufactured goods to also raise prices once food price inflation is anchored at a high level. This happens with a lag of two-three quarters. In fact, often producers absorb higher input costs to begin with before transmitting the same to the final consumer. For example, higher wages paid by movie theatres get reflected in higher ticket prices.

Therefore, it may not be prudent to ignore food inflation from the point of view of monetary policy as there are strong linkages with other parts of the price index. Further, by keeping interest rates higher when food inflation is high, it helps in preventing the build-up of excess demand pressures. This is why it is often argued that monetary policy has to be reactive and keep looking continuously at the rear-view mirror. The precise impact of food shocks on inflation is hard to guess. The price shocks either last for a couple of weeks, or get entrenched in the system and become durable.

This is why it is observed that central banks target headline inflation and do not ignore food inflation. In India especially, consumption trends of food products have changed greatly with demand-side factors coming into play. Ignoring this aspect of inflation will mean missing one significant piece of the puzzle.

Indian agencies should get into sovereign ratings: Buisness Line 8th October 2024