Central Banks to the rescue - Outside View by Asad Dossani

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Central Banks to the rescue
Jan 18, 2011

In recent weeks and months, there has been a general increase in commodity prices. The rise in prices of agricultural and energy commodities has been sustained and is starting to have adverse effects. Food price inflation especially affects poorer people for whom food expenditure makes up a significant portion of their total consumption. The last time that food prices reached these levels in 2008, many countries saw riots.

Brent crude oil nearly reached USD 100/barrel last week. Energy price increases tend to affect the entire economy. Costs of production go up for businesses - thus reducing profitability and future investment. This in turn has a negative impact on total employment and national income. Finally, consumers themselves will suffer from higher utility and transport bills.

The way in which a society suffers from rising commodity prices is inflation. Increased prices of food and raw materials increase the price of everything else too. Our incomes dont grow at the same rate, so we become worse off. Like when anything else in the economy goes wrong - central banks come to the rescue.

Central banks of many countries are concerned about rising inflation due to increased commodity prices. They want to do something about it - they want to stop this inflation from occurring. Is this possible? Central banks have control over their own money supply through the use of the interest rate. Increasing the interest rate reduces borrowing and investment, and consequently inflation.

Excess inflation primarily occurs for two reasons. The first is when money supply is increasing too quickly. Increasing amounts of money chasing the same number of goods leads to higher prices - and this is the type of inflation the central bank can and should prevent through higher interest rates.

Inflation can also be caused by supply and demand factors. Oil prices will increase because of high growth in emerging economies. Food prices will increase because of poor harvests due to bad weather. These are real factors that have nothing to do with nominal (money supply) factors.

If a central bank tries to raise interest rates in response to commodity price inflation, it will not work. In fact, it will only make things worse. The only way to have lower food prices is if we produce more food. The only way to have lower energy costs is to become less reliant on oil and find alternatives. Both of these objectives require long-term investments in better technology. Raising an interest rate does not achieve this.

If central banks do raise rates, the likely effect will be reduced economic activity - which may in turn lead to lower commodity prices (due to lower demand), but does make everyone worse off overall. It is important for countries and governments around the world to recognize that there is no quick fix for commodity price inflation, and the only solution is long-term.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

Equitymaster requests your view! Post a comment on "Central Banks to the rescue". Click here!

  

More Views on News

Sorry! There are no related views on news for this company/sector.

Most Popular

These 5 Penny Stocks are Held by Rakesh Jhunjhunwala. Worth a Look? (Views On News)

Jan 18, 2022

Rakesh Jhunjhunwala is holding these penny stocks in his portfolio for several years now.

Tech Mahindra's CTC Acquisition: Too Expensive? (Views On News)

Jan 18, 2022

Tech Mahindra's acquisition of European IT-company fails to excite investors.

5 Hidden Tata Group Companies to Add to Your Watchlist (Views On News)

Jan 18, 2022

Here's all you need to know about these five Tata group stocks that aren't as popular as the others.

Insiders are Buying into these 6 Stocks Aggressively. More Details here... (Views On News)

Jan 19, 2022

While promoter holding is an important parameter, it should not be the sole reason for buying a stock.

Top Indian Drone Companies to Watch Out for in 2022 (Views On News)

Jan 21, 2022

Several companies are adopting drone technology for regular business operations.

More

Become A Smarter Investor
In Just 5 Minutes

Multibagger Stock Guide 2022
Get our special report Multibagger Stocks Guide (2022 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

MARKET STATS