Central bank policymakers have been in the spotlight as they continue to curtail the negative effects of the pandemic on the economy. Policymakers have various fiscal and monetary tools at their disposal when trying to stimulate a slowing economy.
One of the key indicators that policymakers must be mindful of while reducing interest rates is the inflation rate
Central bank policymakers have been in the spotlight as they continue to curtail the negative effects of the pandemic on the economy. Policymakers have various fiscal and monetary tools at their disposal when trying to stimulate a slowing economy.
One of the monetary tools that the central bank has at its disposal is the lever to interest rates. In India, the Monetary Policy Committee (MPC) is in charge of fixing the benchmark interest rates. Generally, interest rates are reduced to increase liquidity in the economy with the expectation that the ease of access to credit will increase borrowing and spending which is positive for the economy.
One of the key indicators that policymakers must be mindful of while reducing interest rates is the inflation rate. Inflation, as many already know, is the rate at which prices of goods increase over a specific period of time. A nominal rate of inflation for a developing economy is a healthy sign. It indicates that consumers are willing to spend money on goods and services rather than save money which in a nutshell is better for the economy. However, too much inflation is detrimental to an economy as it causes the value of a currency to depreciate and the amount of goods and services that can be purchased by a fixed sum of money reduces.
Therefore, the biggest challenge for an individual is to protect their capital from depreciation due to inflation.
In an economic environment with nominal inflation, individuals can beat inflation by investing in fixed income securities like government bonds and corporate papers. But, since April 2020, the inflation rate has increased beyond 6 per cent on account of various factors among which the most prominent was the supply constraints enforced due to global and national lockdowns.
With the equity markets at all-time highs, investors all over the world are trying to understand what is driving this rally despite the economic situation not improving as rapidly.
As we look forward to the inflation numbers for December and the year 2020, the high inflation rate has kept the MPC’s hand-tied as they look forward to the gradual economic recovery to normaliSe inflation rates. The effect of high inflation on investment behaviours is one of the most talked-about topics.
As mentioned earlier, high inflation is negative for the entire economy but the investment behavior of institutions and individuals varies. Investments - CAPEX - by institutions increases when the cost of capital reduces hence lower interest rates are beneficial for them. High inflation has two effects in this process,
1) it reduces the real cost of capital, and
2) it eats away at the value of reserves and therefore it is lucrative to invest the reserves
On the other hand, for individuals, investments in fixed return instruments become a lot less lucrative as the purchasing power of those future cash flows depreciates. The price of these bonds depreciates as demand drops and the yield increases. Conversely, investments with adjustable cash flows like property rental income perform better. In the stock markets, investors aiming for a higher return to beat the inflation rates choose to invest in riskier assets like equity instruments. This drives additional liquidity in the market causing stock prices to rise as inflation increases. The caveat here is that businesses that offer discretionary goods and services will see a lower volume of sales as high inflation curbs consumer spending. Therefore, the divergence between net profit and the secondary market value of companies increases.
The author is the Co-founder and CIO of True Beacon and Zerodha