Economy: Inflation in the ambush?

The Reserve Bank of India (RBI) continues to maintain its stance of 'comfort' with regards to the current rate of inflation despite the firmness in crude oil prices, booming asset prices and inherent pricing pressures in the financial sector. However, going by the principle of 'overheating of the economy', one wonders whether there are inflationary threats in the offing. Global paradoxes...

Low inflation despite abundant liquidity and increasing asset prices
The global economy is currently awash with liquidity. The policy accommodation pursued until recently by the US has had a global impact, flooding the rest of the world with an abundance of liquidity. Low interest rates in the US have encouraged capital to flow into emerging market economies. For the countries that prefer some form of managed parity against the US dollar, this has resulted in large build-up of foreign exchange reserves and excessive domestic liquidity, amplifying the Fed's policy stance. Yet, the global supply of dollars is estimated to have grown by around 25% p.a. in the last couple of years (Source: The Economist).

The global glut of liquidity has facilitated highly leveraged positions, debt financed consumption and booming credit growth, raising financial stability concerns. Perhaps the greatest paradox in current global developments is the co-existence of abundant liquidity and low consumer inflation. Infact, with monetary policies all over the world remaining accommodative, inflation has been unusually benign, impervious to soaring oil prices and the elevated prices of non-fuel commodities particularly ferrous and non-ferrous metals.

Low savings and investment despite surge in growth
The world savings and investment rate has declined steadily over the past decade. Notwithstanding the declining saving and investment rates, global growth has continued its surge from period to period. While consumption has arguably played a critical role in the industrial countries' growth momentum, exports might have played a similar role in the emerging markets. The sustenance of consumption as opposed to investment-led growth has thus given rise to new controversies on present versus future allocation of resources.

...trickling down to India
From a peak of 8.5% in 1HFY05, the headline inflation rate declined to 5.5% in January 2005 and has remained largely below the central bank's comfort zone of 5% to 5.5% over the past 10 months. The inflation rate has declined significantly over this period due to a deceleration in the year on year price trend for global commodity linked products. The government's tinkering with domestic oil prices has also helped this trend. However, the swing in the current account from surplus to deficit, high risk appetite in the banking system and the sharp rise in property prices are all reflections of the current relatively low level of real interest rates. Although the RBI remains committed to tightening the money supply with its monetary policy measures, threats of sudden reversal in global liquidity conditions and interest rate arbitrage warrant caution from a sudden disruptive liquidity crunch.

Will this help?
On one hand, the RBI has forbidden banks from raising their interest charge on the credit lent to corporates. On the other hand, bank themselves are rigid in terms of risking a rate hike for the retail clients, lest they lose out on the potential credit stream. The 'justification' for this has been on the premise of 'surplus liquidity' in the system. What does not seem to be on the minds of the apex bank and the banking behemoths is the fact that while the 'cheap funds' will facilitate higher capex and consumer spending, lower real interest rates will discourage savings and investment. Infact, the sustenance in high crude oil and asset prices will only make matters worse in terms of contraction in real interest rates.

It thus remains to be seen to what extent the central banks all over the world can dodge the ambushing inflation with their 'measured' policies.