The real reason why inflation won't go away

Aug 8, 2014

In this issue:
» What does Buffett's favorite macro indicator say?
» Half of America thinks that the recession never ended!
» Chinese banks finally wake up to their bad debt problem
» What do stocks have in common with cows?
» And more!

'Inflation is always and everywhere a monetary phenomenon.' This was the famous statement made by the Nobel Prize winning economist Milton Friedman. It basically means that the real cause of rising prices is an increase in the amount of money supply. When applied to the Indian context, it can help explain why prices never seem to come down. Allow us to explain.

Without getting too technical, Friedman's statement simply means the following. Whenever, the quantity of money in an economy increases faster than the GDP prices will rise. This, we believe, is the real long-term cause for structural inflation. Here we are not referring to the short-term spikes in food prices due to hoarding or the delayed monsoon. By 'structural inflation' we mean a general rise in the price level. After all, what does a movie ticket have in common with pulses? Nothing at all but the prices of both has multiplied over the years. This cannot be due to bad weather, high oil prices or speculators. Nor can it be explained by wars in the Middle East. The real reason is the supply of money which has increased over the years at an annual rate above 15% for several decades. The Indian economy, on the other hand has grown at a far slower rate. This has led to a constantly rising cost of living in the country.

Now we all know that the US government has run huge deficits for several years. The US fed has helped out by printing money whenever needed. The Quantitative Easing (QE) policy is just an example of this. But what about India? It is interesting to note that the Reserve Bank of India (RBI) has funded more than one-fourth of the government's borrowing program in the last few years. Why is this important? Well, this money from the central bank has helped the Indian government spend far more than what it could have otherwise. It has allowed the government to transfer huge amounts into welfare schemes. A lot of this money was siphoned off and never reached India's poor. Thus the quantity of money kept on increasing at a much faster rate than India's growth. This has led to India's structural inflation problem. So does this mean that the RBI must share some of the responsibility for this? We don't believe so.

In India, it is the government that decides how much it is going to borrow. This amount of borrowing in turn will determine the increase in the quantity of money. Thus, unless the government gets a grip on its own finances, the money supply will go on increasing. Short-term measures like tinkering with customs/excise duties and imposing the Essential Commodities Act on speculators will not solve the problem. The RBI governor Raghuram Rajan has quite rightly stated that India must solve this structural inflation problem as soon as possible. Otherwise, the cost of living for the common man will keep increasing year after year. Even corporates will not be spared. Structural inflation tends to last across the entire economic cycle. During periods of high GDP growth, even firms with poor pricing power will do well. However, when the down turn hits, only the most cost efficient firms with strong pricing power will survive to create long term wealth. So far the Modi government has shown its intent to control spending but we haven't seen many concrete measures being implemented. History will remember the previous UPA government as a failure on the inflation front. We certainly hope that this government's legacy does not end up the same way.

Do you think the government will be able to control inflation? Let us know in the Equitymaster Club or share your comments below.

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 Chart of the day
You'll rarely see Warren Buffett talk about market wide valuations. He simply prefers to invest in individual stocks and buys into them if he thinks they are available at good prices. However, the few times he's focused on the market valuations, he's tended to use an indicator called the market cap to GDP ratio. As per Buffett, this is the single best indicator to see where the market valuations are at any given point in time. A leading daily has taken a leaf out of Buffett's book. It has used the very same indicator to find out where Indian markets stand at the moment.

So, what's the conclusion? Well with India's market cap being 70% of its GDP currently, the market is just about fairly valued as per the indicator. Important to add that the long term average stands at around 72% and when the ratio goes up above 100%, like it did in 2008 when it touched 102%, alarm bells should start ringing. However, there does not seem to be any such concern for the time being and investors looking to invest in say index funds, can still walk away with good returns from a long term perspective we reckon.

Indian markets are fairly valued

Here is an interesting development in the cement industry that drew our attention. Some real estate developers in South India are considering setting up their own cement manufacturing units. They believe this will help them meet their cement requirement at lower costs. Cement players and real estate developers have been at loggerheads as far as cement prices are concerned. On one hand, cement players are unwilling to pull back cement price hikes. The reason being the significant rise in input costs such as coal, power and transportation. Real estate developers, on the other hand, are unwilling to budge. Several builders have stopped purchases for quite a few weeks.

It may be worth mentioning here that of the total cement capacity in the country, over one-third capacity comes from south India alone. Factors such as the political crisis in Andhra Pradesh, severe power outages and overall economic slowdown have severely impacted cement sector growth in the region. As per an article in Economic Times, the cement industry in the south has grown at a meager rate of 1% CAGR over the last four years. Many players have been making losses because of low capacity utilization rates and high costs. Whether the property developers are right about setting up their own facility is a different matter. But these developments certainly highlight the troubles engulfing the cement sector in the southern part of the country.

There is a popular belief that rural India has so far remained aloof to the India growth story that Dalal Street depicts. Rapid rise in stock prices have hardly benefitted these daily wagers is the common notion. However, this is an illusion we believe. Not only do they have an avenue that generates stock like returns at their disposal. But they have also made a bounty of it. And this avenue is nothing but cow, our holy mother, as per Hindu mythology. Yes, you read it right. Its cows!

A recent research by a team of economists has revealed that rural Indians investing in cows and buffaloes could be acting rationally. That's because cows could well be trading at their bottoms now. Readers may help note that cow prices, like equities are quite volatile. During drought years, fodder could be scarce and thus profits can be low. Going by the same logic, during non-drought years profits could be high. And with monsoons covering India by now, the fear of drought has died down. As such, cows could give good returns now.

Basically, cows are an asset whose return varies depending upon fodder availability and monsoons, the same way like equity return varies with fundamental factors. The rural Indians know this pretty well. And are actively buying and selling cows thereby generating stock like returns. The only difference being their predictive power is more accurate as there are limited factors that influence prices of cows than equities.

2008 may have been a nightmare for the Americans. At least that is what the rest of the world thinks! But not the Americans. For them, the nightmare never ended. The rest of the world moved ahead leaving behind the memories and taking lessons from the Lehman bankruptcy. But the economic recession that the citizens of the US started getting subjected to, never really went away. Little wonder then as per a survey by Huffington post, nearly half of the Americans think that the economy is still in recession. Well, economists, President Obama and the Federal Reserve may like to prove otherwise with their economic statistics. But the fact remains that the excess cheap liquidity has not helped improve the living standards of ordinary Americans. Those without jobs for months have stopped searching for any. And while the Fed may take credit for reducing job crisis, people continue to remain without jobs. It is time that the US government, central bank and economists start looking at real data rather than economic statistics.

First it was India, now China! Asian economies are strengthening their guard to battle out the domestic challenges and the rising global uncertainties. Yesterday's 5 Minute WrapUp had mentioned about the Indian Central Bank Governor keen on ridding the banking system of dodgy activities. Today we read about China. Yes, China too has followed suit. Chinese banks have been high on diligence over credit offtake. Trimming risky exposures and tightening the lending terms is now the prerogative for most of the Chinese banks. Many have deployed special teams of investigators to assess the risk of loan defaults. Credit exposure to state-owned enterprises is becoming the flavor of the season. Needless to mention the less risky profile of the stated-owned companies!

Chinese banks have also been demanding higher collateral to prevent the risk of bad debts swell. Notably, the bad-loan ratio for Chinese banks has reached a record high. Besides, the shadow banking system has been constantly raising its ugly head. Moreover, the sanctity of Chinese data releases is also questionable. Therefore, it is a long way to go for Chinese banking system to overcome the formidable challenges.

The Indian stock markets continued to trade deeper in the red in the afternoon trading session. At the time of writing, the BSE-Sensex was trading lower by 341 points (-1.3%). All the sectoral indices were trading in the red. Realty and metal stocks were witnessing maximum selling pressures. Barring China, all Asian markets were trading weak with Japan and Korea leading the losses. European markets also opened the day on a negative note.

 Today's investing mantra
"Don't buy a stock just because everyone hates it." - Warren Buffett

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7 Responses to "The real reason why inflation won't go away"

Sarat Palat

Aug 9, 2014

Do the necessary to reduce the population growth. Both the Govt. and the citizens should think about this. In simple economics, this is because of demand and supply factor.


Ashok Kumar Sethi

Aug 8, 2014

The inflation, the price rise and standard of living of people all the time show upward trend because the GDP remains at lower growth and the increase in population is in heaps and bounds. Our interest rates will never come below to 2% because the money supply in quantity is at increase. None of the Govt. can check the price rise. That was the time of 1960 when the payment of Rs 135/-to 150/- to a working Babu was considered enough and sufficient to support their family members consisting of 5 to 6 members.Within the gap of 55 years much has changed and todays Babus salaries running into few Ks are even not sufficient because our standard of living has tremendously changed. We, the Indians have to bring changes to our life style and Simple thinking and living has to be adopted by us to check the menace of inflation and price rise making us more productive in helping growth of GDP.



Aug 8, 2014

Even a comman man at street can tell that Govt. can't bring prices down. But, Govt. can certainly kill industry by keeping interest rates high. UPA n BJP has almost same vision and time will prove it.


ashwani kumar khare

Aug 8, 2014

I need an explanation about how newly printed money enters the economic system. Money is printed in government press. At the time of printing government is the owner of this new money. How do they introduce this in economic system to support monetary transactions which has increased due to increasing GDP due to increased economic activities. The increased GDP is by residents of that nation who have become more economically active(producing more) and thus increasing the GDP, therefore they should create methods to increase money in the market to facilitate increasing transactions.
Please reply also to my email address also.
Ashwani Kumar Khare


krishna Murthy

Aug 8, 2014

You can not chew more than what you can swallow. Past one decade or so these useles economist had played this type of looting which resulted in the catch 22 situation.


Ravi Muthuswamy

Aug 8, 2014

But what is the incentive for the govt to reduce the money supply when the benefits are longer term and that to when the reduction is sustained? As this is unlikely to happen given the political climate the alternative is to work on improving GDP and productivity of funds deployed.



Aug 8, 2014

As long as the goverment does not allow printing of INR 10/-
INR 50/- & 100/- notes & readily available of coins of all denominations, inflation will never come down.
It is rediculous if the vegetable vendor offer lime, as no change is available or a shopkeeper gives eclair choclates.
Are we living in a world where banks openly tell their clients that denominations required by you r not available.
It is indeed a very sorry affair.

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