The Death Of Inflation : Living Under Low Inflationary Expectations



The sudden drop in the Dollar:: In March 2017 was seen as a political phenomenon, part of the Trump Trade. It was imagined that Trump initiated his “cheap dollar’ policy by calling in his prominent trading partners, and arm-twisting them into strengthening their respective currencies against the Dolla. Different countries reacted differently, some (like China) set up diversions (like the North Korean brouhaha) to get Trump on the backfoot; some others (like India) capitulated.

Declaimer: This article was originally in November 2017, and some of the data points may be outdated

The Art of War

China is the country where The Art Of War was first written, so one presumes, that they have internalized its principles and it is part of their culture to quote from, and obey, its principles. India is still to learn enough from it, and we don’t even recognize a Currency War when it hits us on the nose. Be that as it may, Economics has a way of catching up after Politics has done its bit.

The fall of the Dollar, or the rise of the Re, was seen as a harbinger of the Death Of Inflation. By June-July, inflation was down to 1.3%, the Dollar: Re was at 64, and there were Bank reports pointing to 61-62.

The End of Inflation

And the market had started to build up a consensus towards the end of Inflation. As Mark Twain said on hearing about rumors of his death, “Reports of my death are grossly exaggerated”. A single one-month tick down, driven partly by the rise of the Re and the drop in imported Inflation, is hardly reason to come to such a consensus. But it brought the Forward Premium down from 40p to about 22p, and it continues in that range. This works out to about 4% on the current spot price of Rs.65, which is the anticipated inflation differential.

But inflation is not dead, and long live inflation. The Govt launched a Stimulus package, and nobody was less surprised than me. What did surprise me, however, was how market commentators were quick to call the demise of inflation, and draw consensus calls for the Re appreciation, quoting Economics to justify what was a political decision.

The RBI’s decision to back away from supporting the Dollar (at 67.20, its 180DMA) was a tactical decision, that was justified in the subsequent commentary by pointing towards the export growth (driven, ostensibly by sharply rising productivity). It’s not like this productivity was suddenly evident and the Dollar: Re dropped 7% in roughly a month. The RBI was facing unprecedented flows, with the threat of more if it kept defending the Dollar; hence, it backed off, and the Govt justified a tactical action based on a strategic re-assessment of India’s macro-fundamentals.

But this was in March, before Trump started to look like a paper tiger, thanks to North Korea’s calling of his bluff. By June-July, the market, media, Banks, and commentators were all prone to rationalizing what was an irrational movement. So people started using Economics to justify what was a political decision. That led to this spate of Bank reports pointing to 61-62, even 60 (one Bank had 58 as a long-term target).

Inflation reared its head thereafter, and RBI has raised its prognosis very clearly. In 2 sharp panics, the Dollar: Re spiked twice, from 64 to 65.20 and then from 64 to 65.88. The latter move finally broke the market’s consensus, and the Dollar was supported at 64.80 levels. I think it should settle into a range of 65-66 hereon, for the next 6 months.

The idea behind this article is to put up a voice against the flawed consensus. One is that the Re is on an appreciating trajectory. Two, that this is because of the end of Inflation, or rising Indian productivity. Nothing of the sort is happening. What happened, was that the RBI was sleeping at the gate in March….it ran with its tail between its legs when the tidal wave (of flows) hit, and then the pundits justified what was happening based on some productivity increase they suddenly saw. The second time round, when the market sounded the death knell to inflation in June-July, the Govt was better prepared with its stimulus package, which brought back Inflationary Expectations. Helped along by a somewhat flawed monsoon (and food prices), we are back to our new normal of 4-6%, and the Forward curve has stabilized where it is.

Indian productivity continues

Indian productivity continues to trundle along in the region of 1.2%, with nothing new to report. From here onwards, those with import risks should expect a steadily rising Dollar from now on, so please start hedging your imports again. And I think the RBI is back at the gate, and will protect the inflation differential line, which now starts from 64 in March, depreciating at the rate of 4%, i.e., Rs.2.5 per year. In September, therefore, it should have reached 65.20, so Dollar: Re should trade above 65 for the rest of the year.

Structurally, the components of inflation are as follows. One, the Fiscal deficit contributes to core inflation. Yes, there’s good news there and it is structural. As long this Govt stays in place, the part of inflation that is driven by excess Govt expenditure (and the wrong composition, i.e., NREGA-type handouts), will be controlled. Even Govt handouts, such as they are, will be more asset-creating in nature, and will not contribute to a simple increase in money supply. Two, supply-side constraints, especially in food production, are not going away any time soon. This will require long-term investments in desalination, waste-water management, input management, and land use, which will take time to roll out. Food inflation is here to stay for quite some time now. This is probably the biggest area for the Modi Govt, that still needs some doing……

Three, fuel inflation is going to be muted, helped along by a world heading to deflationary costs in energy through technological change. Oil fuel will shift to electric, and solar/ wind will drive down the cost of electric power to zero. India is well on its way, moving elephant-like, slowly but firmly, towards clean, cheap, sustainable energy.

Fourth, manufacturing inflation is not yet much of a threat. Capacity utilization is still low, although it is slowly rising. The cost of debt is steadily coming down, and will not go back much, thanks to more financial savings getting parked in the Banks. From a market perspective, this will create a very long bull market. Some of the youngsters will be in middle age by the time this bull market ends.

the components of inflation

So, to summarise, many of the components of inflation may be muted, but there’s life left in those old bones, don’t write the old man off yet. The Govt has plenty of cheques left to write, and handouts are not ending any time soon, although they are changing character. Fuel-related inflation should go into long-term decline, even structural deflation (although for the rest of this year, it is adding a substantial part of the inflation uptick), but food inflation will be alive and kicking. Manufacturing will structurally lose pricing power, as a consolidated industry gets lower borrowing costs and access to a bigger pool of savings. But I would lay my maximum trust in the essential nature of an Indian governance, which believes in government finances staying in deficit.

There’s a reason to point out all this. Let’s stop looking for a downward trajectory to Dollar: Re, and go back to our long-held habit of looking towards the heavens. Importers have stopped feeling scared, and that is never a good thing.



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