The Indian story is easier to understand, demonetization and after that re-monetization has created two shocks, none of which have worked well on price stability and the abrupt change in CPI in February’17 hold testimony to this.
Conventional theory on inflation would suggest that excess money supply causes inflation as too much money follows too few goods. But in this case the opposite happened that too little money created the supply shocks in those commodities that weigh high in the basket for CPI, thus raising prices in February’17.
And this is after the best of conditions for farm supply.
This is like hoarding that takes out stock of some commodities from the market; it is bound to raise prices. But there are a myriad of reasons that work at cross-purpose as well.
The real movement in inflation is almost always guided by monetary policy, so what lags what is quite a puzzle. Think for example that banks are able to lend at constant rates and lending increases over time, this delta would impact prices over the medium to long term. But Indian bank lending has dwindled as this chart says it all.
Let us turn our attention on the U.S. economy; it needed several bouts of QE that allowed Federal Reserve to buy asset backs securities that dampened interest rates as excess liquidity held by commercial banks had to be disposed of finally. That led to heightened pace of activity in the financial sector followed by slow and steady rise in activity in the real sectors of the economy. While the unemployment rates fell, the impact on prices was minimal. This was a clear case of ‘trickling’ that failed to tick. The low interest rate environment created enormous room for profits in the financial sector as stocks buoyed on the back of good corporate results. But soon lack of investments created the squeeze in supply that had only one avenue, prices and the inflation at long last ticked upwards.
This is one example of inflation push when lack of investments was the driver not the excess money supply as there were other absorbers in the economy to take the brunt of the excess, like stocks.
For all we know this inflation uptick could be temporary, but going by the almost unanimous decision by the Federal Reserve to raise the Federal Funds Rate twice this year, it seems that the impact would be for long not short.
The excess liquidity is now slowly but steadily being taken out of the system; the commercial banks however still have hugely bloated ‘excess reserves’ sitting at the Federal Reserve balance sheet which could attract an interest rate of 1% from the Fed.
The buy-backs have always provided enormous opportunity for Earnings per share ratio to move up as the denominator has pushed the average up with less and less outstanding shares. This as an economic option looks best given the lack of investment options in the real economy.
But inflation expectations could be a dampener to all this. If the infrastructure investments do not happen, the inflation expectations will not fall but rise as too less goods and services are going to be available for the same supply of money. The numerator of the ratio depends on this as well.
The tax reform comes as a mixed bag as well as it would generate additional room for disposable income to be spent, if that is only available to the super-rich, the application of such excess funds normally follow the financial sector.
The simultaneous move to open up public-private infrastructure space therefore becomes the only avenue for a potential solution to the puzzle.
The new President cannot fail twice and he is reminded more than once that the last President united the Republicans for the last time. He would have to solve some puzzles before he can get the economy back into ticking speed.
Let us all hope he succeeds in this.