Is Rajan trying to do what Paul Volcker did in the US ?

ARTS RAJANVivek Kaul  
Going against market expectations Raghuram Rajan, the governor of the Reserve Bank of India(RBI), raised the repo rate yesterday by 25 basis points (one basis point is one hundreth of a percentage) to 7.5%. Repo rate is the interest rate at which RBI lends to banks.
It was widely expected that Rajan will cut the repo rate. But that did not turn out to be the case. In his statement Rajan explained that he was worried about inflation. As he said “recognizing that inflationary pressures are mounting and determined to establish a nominal anchor which will allow us to preserve the internal value of the rupee, we have raised the repo rate by 25 basis points.”
The RBI’s Mid-Quarter Monetary Policy Review echoed a similar sentiment. “What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence. Although better prospects of a robust 
kharif harvest will lead to some moderation in CPI inflation, there is no room for complacency,” the statement pointed out.
as I explained yesterday, believes in first controlling inflation, instead of being all over the place and trying to do too many things at once. As Rajan wrote in a 2008 article (along with Eswar Prasad) “The RBI already has a medium-term inflation objective of 5 per cent…But the central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”
And given this the RBI ends up being neither here nor there. As Rajan put it “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”
Hence, Rajan felt that the RBI should ‘just’focus on controlling inflation. As he wrote in the 2008 
Report of the Committee on Financial Sector Reforms “The RBI can best serve the cause of growth by focusing on controlling inflation and intervening in currency markets only to limit excessive volatility…an exchange rate that reflects fundamentals tends not to move sharply, and serves the cause of stability.”
Given this, Rajan’s strategy seems to be similar to what Paul Volcker did, as the Chairman of the Federal Reserve, to kill inflation in the United States, in the late 1970s and early 1980s. On August 6,1979, Volcker took over as the Chairman of the Federal Reserve of United States .
When Volcker took office, things were looking bad for the United States on the inflation front. The rate of inflation was at 12%
. In fact, the inflation in the United States had steadily been going up over the years. Between 1964 and 1968, the inflation had averaged 2.6% per year. This had almost doubled to 5% over the next five years i.e. 1969 to 1973. And it had increased to 8%, for the period between 1973 and 1978. In the first nine months of 1979, inflation had averaged at 10.75%. Such high inflation during a period of peace had not been experienced before. As inflation was high people bought gold. On August 6, 1979, the day Volcker had started with his new job, the price of gold had stood at $282.7 per ounce. On August 31, 1979, gold was at $315.1 per ounce. By the end of September 1979, gold was quoting at $397.25 per ounce having gone up by 26% in almost one month.
On January 21, 1980, five and a half months after Volcker had taken over as the Chairman of the Federal Reserve of United States, the price of gold touched a then all time high of $850 per ounce.
In a period of five and a half months, the price of gold, had risen by an astonishing 200%. What was looked at as a mania for buying gold was essentially a mass decision to get out of the dollar. Given this, lack of stability of the dollar, Volcker had to act fast.
After he took over, the first meeting of the Federal Open Market Committee (FOMC) was held on August 14,1979. FOMC is a committee within the Federal Reserve, the American central bank, which decides on the interest rate. The members of the committee expressed concern about inflation but they seemed uncertain on how to address it.  In September 1979, the FOMC raised interest rates. But it was split vote of 4:3 within the seven member committee, with Volcker casting a vote in favour of raising interest rates. Volcker clearly wasn’t going to sit around doing nothing and came out all guns blazing to kill inflation, which by March 1980 had touched a high of 15%. He ] kept increasing the interest rate till it had touched 20% by January 1981. This had an impact on inflation and it fell to below 10% in May and June 1981. 
The prime lending rate or the rate, at which banks lend to their best customers, had been greater than 20% for most of 1981. 
Increasing interest rates did have a negative impact on economic growth and led to a recession. In 1982, unemployment rate crossed 10%, the highest it had reached since 1940 and nearly 12 million Americans lost their jobs. During the course of the same year nearly 66,000 companies filed for bankruptcy, which was the highest since the Great Depression.
And between 1981 and 1983, the economy lost $570 billion of output. 
But the inflation was finally brought under control. By July 1982, it had more than halved from its high of 15% in March 1980. The steps taken by Paul Volcker ensured that the inflation fell to 3.2% by 1983.
By continuously raising interest rates, Volcker finally managed to kill inflation. This ensured that the confidence in the dollar also came back. By doing what he did Volcker established was that he was an independent man and was unlike the previous Chairmen of the Federal Reserve, who largely did what the President wanted them to do.
In fact, when Arthur Burns was appointed as the Chairman of the Federal Reserve on January 30, 1970, Richard Nixon, the President of United States, had remarked that “I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed.”
The feeling in the political class of India is along similar lines. The finance minister expects the governor of the RBI to bat for the government. But that hasn’t turned out to the case. The last few RBI governors (YV Reddy, D Subbarau) have clearly had a mind of their own. And Raghuram Rajan is no different on this front. His decision to raise interest rates in order to rein inflation is a clear signal of that.
But the question is can the RBI do much when it comes to controlling consumer price inflation(CPI)? Can Rajan like Volcker did, bring inflation under control by raising interest rates? Or can he just keep sending signals to the government by raising interest rates to get its house in order, so that inflation can be brought under control?
In India, much of the consumer price inflation is due to food inflation, which currently stands at 18.8%. While overall food prices have risen by 18.8%, vegetable prices have risen by 78% over the last one year. As a 
discussion paper titled Taming Food Inflation in India released by Commission for Agricultural Costs and Prices (CACP) in April 2013 points out, “Food inflation in India has been a major challenge to policy makers, more so during recent years when it has averaged 10% during 2008-09 to December 2012. Given that an average household in India still spends almost half of its expenditure on food, and poor around 60 percent (NSSO, 2011), and that poor cannot easily hedge against inflation, high food inflation inflicts a strong ‘hidden tax’ on the poor…In the last five years, post 2008, food inflation contributed to over 41% to the overall inflation in the country.”
The government procures rice and wheat from farmers all over the country at assured prices referred to as the minimum support price. This gives an incentive to farmers to produce more rice and wheat for which they have an assured customer, vis a vis vegetables.
As a discussion paper titled 
National Food Security Bill: Challenges and Options released by CACP points out “Assured procurement gives an incentive for farmers to produce cereals rather than diversify the production-basket…Vegetable production too may be affected – pushing food inflation further.”
There is not much that the RBI can do about this. As Sonal Varma of Nomura Securities puts it in a report titled RBI Policy – A Regime Shift “Inflationary expectations are elevated primarily due to supply-side driven food inflation. In the absence of a supply-side response, severe demand destruction may become necessary to lower inflationary expectations.” Hence, it remains to be seen how successful the Rajan led RBI will be at controlling inflation.
The article originally appeared on on Septmber 21, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Try Again. Fail again. Fail better – Disaster formula of US Federal Reserve

Bernanke-BubbleVivek Kaul
Now we know better. If we learn from experience, history need not repeat itself,” wrote economists George Akerlof and Paul Romer, in a research paper titled Looting: The Economic Underworld of Bankruptcy for Profit.
But that doesn’t seem to be the case with the Federal Reserve of United States, which seems to be making the same mistakes that led to the financial crisis in the first place. Take its decision to continue printing money, in order to revive the American economy.
In a press conference to explain the logic behind the decision, Ben Bernanke, the Chairman of the Federal Reserve of United States, said “
we should be very reluctant to raise rates if inflation remains persistently below target, and that’s one of the reasons that I think we can be very patient in raising the federal funds rate since we have not seen any inflation pressure.”
The Federal Reserve of United States prints $85 billion every month. It puts this money into the financial system by buying bonds. With all this money going around interest rates continue to remain low. And at low interest rates the hope is that people will borrow and spend more money.
As people spend more money, a greater amount of money will chase the same number of goods, and this will lead to inflation. Once a reasonable amount of inflation or expectations of inflation set in, people will start altering their spending plans. They will buy things sooner rather than later, given that with inflation things will become more expensive in the days to come. This will help businesses and thus revive economic growth.
The Federal Reserve has an inflation target of 2%. Inflation remains well below this level. As
Michael S. Derby writes in the Wall Street Journal As of the most recent reading in July, the Fed’s favoured inflation gauge, the personal consumption expenditures price index, was up 1.4% from a year ago.”
So, given that inflation is lower than the Fed target, interest rates need to continue to be low, and hence, money printing needs to continue. That is what Bernanke was basically saying.
Inflation targeting has been a favourite policy of central banks all over the world. This strategy essentially involves a central bank estimating and projecting an inflation target and then using interest rates and other monetary tools to steer the economy towards the projected inflation target. The trouble here is that inflation-targeting by the Federal Reserve and other central banks around the world had led to the real estate bubble a few years back. The current financial crisis is the end result of that bubble.
Stephen D King, Group Chief Economist of HSBC makes this point When the Money Runs Out. As he writes “the pursuit of inflation-targetting…may have contributed to the West’s financial downfall.”
King writes about the United Kingdom to make his point. “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation. In other words, credit conditions domestically became excessive loose…The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.”
What this means is that the Bank of England(as well as other central banks like the Federal Reserve) kept interest rates too low for too long because inflation was at very low levels.
Low interest rates did not lead to inflation, with people borrowing and spending more, primarily because of low cost producers in China and other parts of the emerging world.
Niall Ferguson makes this point in
The Ascent of Money – A Financial History of the World in the context of the United States. As he writes Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs. As a result, it was remarkably cheap to borrow money and remarkably profitable to run a corporation.”
The same stood true for the United Kingdom and large parts of the Western World. With interest rates being low banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards.
People who did not have the ability to repay were also being given loans. As King writes “With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, didn’t need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards.” What followed was a big bubble, which finally burst and its aftermath is still being felt more than five years later.
As newsletter write Gary Dorsch writes in a recent column “Asset bubbles often arise when consumer prices are low, which is a problem for central banks who solely target inflation and thereby overlook the risks of bubbles, while appearing to be doing a good job.”
A lot of the money printed by the Federal Reserve over the last few years has landed up in all parts of the world, from the stock markets in the United States to the property market in Africa, and driven prices to very high levels. At low interest rates it has been easy for speculators to borrow and invest money, wherever they think they can make some returns.
Given this argument, it was believed that the Federal Reserve will go slow on money printing in the time to come and hence, allow interest rates to rise (This writer had also argued
something along similar lines). But, alas, that doesn’t seem to be the case.
As Claudio Borio and Philip Lowe wrote in 
the BIS working paper titled Asset prices, financial and monetary stability: exploring the nexus (the same paper that Dorsch talks about) “lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run.”
Once these new round of bubbles start to burst, there will be more economic pain. The Irish author Samuel Beckett explained this tendency to not learn from one’s mistakes beautifully. As he wrote “Ever tried. Ever failed. No matter. Try Again. Fail again. Fail better.”
The Federal Reserve seems to be working along those lines.
The article originally appeared on on September 20, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why the Federal Reserve wants to continue blowing bubbles

Bernanke-BubbleVivek Kaul 

The decision of the Federal Reserve of United States to continue printing money to revive the American economy, has gone against what most experts and analysts had been predicting. The Federal Reserve had also been saying that it plans to start going slow on money printing sooner, rather than later. But that hasn’t turned out to be the case. So what happened there?
When in doubt I like to quote John Maynard Keynes. As Keynes once said “Both when they are right and when they are wrong, the ideas of economists and political philosophers are more powerful than is commonly understood. Indeed, the world is ruled by little else.” The current generation of economists in the United States and other parts of the world are heavily influenced by Milton Friedman and his thinking on the Great Depression. 
Ben Bernanke, the current Chairman of the Federal Reserve of United States is no exception to this. He is acknowledged as one of the leading experts of the world on the Great Depression that hit the United States in 1929 and then spread to other parts of the world. 
In 1963, Milton Friedman along with Anna J. Schwartz, wrote A Monetary History of United States, 1867-1960. What Friedman and Schwartz basically argued was that the Federal Reserve System ensured that what was just a stock market crash became the Great Depression. 
Between 1929 and 1933 more than 7,500 banks with deposits amounting to nearly $5.7billion went bankruptWith banks going bankrupt, the depositors money was either stuck or totally gone. Under this situation, they cut down on their expenditure further, to try and build their savings again. 
If the Federal Reserve had pumped more money into the banking system at that point of time, enough confidence would have been created among the depositors who had lost their money and the Great Depression could have been avoided. 
This thinking on the Great Depression came to dominate the American economic establishment over the years. In fact, such has been Friedman’s influence on the prevailing economic thinking that Ben Bernanke said the following at a conference to mark the ninetieth birthday celebrations of Friedman in 2002. “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
At that point of time Bernanke was a member of the board of governors of the Federal Reserve System. What Bernanke was effectively saying was that in the days and years to come, at the slightest sign of trouble, the Federal Reserve of United States would flood the financial system with money, as Friedman had suggested. That is precisely what Bernanke and the American government did once the financial crisis broke out in late 2008. And they have continued to do so ever since. Hence, their decision to continue with it shouldn’t come as a surprise because by doing what they are, the thinking is that they are trying avoid another Great Depression like situation.
Currently, the Federal Reserve prints $85 billion every month. It pumps this money into the financial system by buying government bonds and mortgage backed securities. The idea is that by flooding the financial system with money, the Federal Reserve will ensure that interest rates will continue to remain low. And at lower interest rates people are more likely to borrow and spend. When people spend more money, businesses are likely to benefit and this will help economic growth. 
The risk is that with so much money going around in the financial system, it could lead to high inflation, as history has shown time and again. To guard against this risk the Federal Reserve has been talking about slowing down its money printing (or what it calls tapering) in the days to come.

Ben Bernanke, the Chairman of the Federal Reserve, first hinted about it in a testimony to the Joint Economic Committee of the American Congress on May 23, 2013.
As he said “if we see continued improvement and we have confidence that that is going to be sustained, then we could in — in the next few meetings — we could take a step down in our pace of purchases.” As explained earlier, the Federal Reserve puts money into the financial system by buying bonds (or what Bernanke calls purchases in the above statement). 
Bernanke had hinted at the same again while 
speaking to the media on June 19, 2013, Bernanke said “If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year…And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”
Given this, the market was expecting that the Federal Reserve will start to go slow on money printing, sooner rather than later. But that hasn’t happened. The consensus was that the Federal Reserve will start by cutting down around $10 billion of money printing i.e. reduce the money it prints every month to around $75 billion from the current $85 billion.
So why has the Federal Reserve decided to continue to print as much money as it had in the past, despite hinting against it in the past? Bernanke in a press conference yesterday said that conditions in the job market where still far from the Federal Reserve would like to see. The Federal Reserve was also concerned that if it goes slow on money printing it could have the effect of slowing growth. “In light of these uncertainties, the committee decided to await more evidence that the recovery’s progress will be sustained before adjusting the pace of asset purchases,” Bernanke said.
Let’s try and understand this in a little more detail. Federal Reserve’s one big bet to get the American economy up and running again has been in trying to revive the real estate sector which has suffered big time in the aftermath of the financial crisis.
This is one of the major reasons why the Federal Reserve has been printing money to keep interest rates low. But home loan(or mortgages as they are called in the US) interest rates have been going up since Bernanke talked about going slow on money printing. 
As the CS Monitor points out “Since Fed Chairman Ben Bernanke first mentioned the possibility of scaling back the Fed’s purchases this past June, the average rate for a 30-year fixed rate mortgage has surged over 100 basis points –sitting at 4.6 percent as of last week – and certain market indicators are showing signs of slowdown.” This has led to the number of applications for home loans falling in recent weeks. 
Also, as interest rates have gone up some have EMIs. 
As an article in the USA today points out “after a mere hint of new policy spiked mortgage rates enough to add $120 a month, or 16%, to the monthly payment on the median-priced U.S. House.” 
Higher interest rates leading to higher EMIs on home loans, obviously jeopardises the entire idea of trying to revive the real estate sector. New home sales in the United States dropped 13% in July. And this doesn’t help job creation. As the USA Today points out “At more than 4 jobs per new single-family home, that means a normal recovery in housing — not a 2005-like bubble — would add 3 million jobs…Moody’s Analytics says. Quick arithmetic tells you that 3 million new jobs would take 1.9 percentage points off the unemployment rate.”
And that is the real reason why the Federal Reserve has decided to continue printing $85 billion every month. Of course, one side effect of this is that a lot of this money will find its way into financial and other asset markets all around the world.
Investors addicted to “easy money” will continue to borrow money available at very low interest rates and invest in financial and other markets around the world. So the big bubbles will only get bigger. 
As economist Bill Bonner writes in a recent column “Works of art are selling for astronomical prices. High-end palaces and antique cars are setting new records. Is this reckless money hitting the stock market too?”
Or as a global fund manager told me recently “
If you look at Sotheby’s and Christie’s, in the art market, they are doing extremely well. The same is true about the property market. Prices have gone up to $100,000 in places which are in the middle of a jungle in Africa. Why? There is no communication. No power lines there.” 
The answer is very simple. The “easy money” being provided by the Federal Reserve will continue showing up in all kinds of places.

The article originally appeared on on September 19, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 


Why the markets are reading too much into Larry Summers' withdrawal from Fed race

larry summers Vivek Kaul 
Larry Summers withdrew from the race to become the next Chairman of the Federal Reserve of United States on September 15, 2013. He was believed to be American President Barack Obama’s favourite candidate. (To read why he withdrew from the race click here)
The markets around the world immediately cheered his withdrawal. This happened primarily because Summers was widely seen to be what in central bank speak is termed as a ‘hawk’. A hawk is someone who is likely to raise interest rates and cut down on money supply.
Summers had said in April this year that “QE in my view is less efficacious for the real economy than most people suppose.” QE stands for quantitative easing and refers to the money that the Federal Reserve of United States, the American central bank, has been printing and pumping into the financial system, in the hope of getting the American economy up and running again.
The idea here is that by flooding the financial system with money, the interest rates will continue to remain low, thus encouraging people to borrow and spend more. With people spending more money, businesses will perform better, and the economic growth would come back.
Summers, it is believed, thinks that the government directly spending money through 
stimulus programmes, would have a greater impact on the economic growth in comparison to the Federal Reserve maintaining low interest rates by printing money and hoping that people borrow and spend more money.
The markets believed that Summers would stop printing money faster than Janet Yellen, the current Vice-Chairwoman of the Federal Reserve, who is now the front runner for the top job at the Federal Reserve.
Currently, the Federal Reserve prints $85 billion every month, which it pumps into the financial system by buying bonds. Ben Bernanke, the current Chairman of the Federal Reserve of United States, has indicated over the last few months that the Federal Reserve will go slow on money printing in the days to come.
This is a big worry for the markets. The idea behind all the money that is being printed has been that at low interest rates people will borrow and spend more money, and thus economic growth will return. But more than that what has happened is that investors have borrowed money available at very low interest rates and invested it in financial and other markets around the world.
This has led to big bubbles in these markets. 
As economist Bill Bonner writes “Works of art are selling for astronomical prices. High-end palaces and antique cars are setting new records. Is this reckless money hitting the stock market too?” Easy money is showing up in all kinds of places.
If the Federal Reserve goes slow on money printing, interest rates are likely to spike, making it difficult for investors who have enjoyed the benefits of the ‘dollar carry trade’ to continue enjoying it. Summers, the markets had come to believe, was more likely to stop money printing faster than any other candidate. And now that he is out of the race, the era of ‘easy money’ policies is likely to continue for a slightly longer period.
The situation needs a slightly more nuanced reading than this. 
As Martin Fridson writes on “The main, rather thin basis for portraying Summers as a hawk was a single remark he made in April about the Fed’s quantitative easing (QE) program: “QE in my view is less efficacious for the real economy than most people suppose.” This was not a major, formal policy statement, but a comment within an official summary of Summers’ remarks at a conference.”
the Federal Reserve’s own research has showed as much. More than that even if a economist believes that quantitative easing hasn’t been effective, that doesn’t mean that he also believes that the Federal Reserve should go slow on it.
As Nobel Prize winning economist Paul Krugman 
writes in a recent column in the New York Times “One answer is the belief that these purchases…are, in the end, not very effective. There’s a fair bit of evidence in support of that belief.” The Federal Reserve puts the money that it prints into the financial system by buying bonds.
Even though, Krugman believes that quantitative easing hasn’t been very effective, he still recommends that it is important to continue with it. “Time for the Fed to take its foot off the gas pedal?” asks Krugman and then goes onto explain why that would not be the right thing to do.
He feels that any suggestion of the Federal Reserve going slow on money printing is going to lead to the long term interest rates in the United States going up. And this can’t be good for the overall American economy, which has just started to show some signs of revival.
Hence, the point here is that even though economists may understand that money printing has not been very effective, at the same time they may not want to go slow on it.
Summers also thinks that government stimulus programmes are likely to be more effective, there was not much that he could do about it. Any extra spending by the American government would mean it would have to borrow more money. This would be a problem given that the government has almost touched its debt limit of $16.7 trillion. 
As the Reuters reports “The government has been scraping up against its $16.7 trillion debt limit since May but has avoided defaulting on any bills by employing emergency measures to manage its cash, such as suspending investments in pension funds for federal workers.”
And more than that the Republicans don’t seem to be in any mood to let the government increase its spending. As an Associated Press news report points out “What’s more, massive fiscal stimulus is highly unlikely given opposition from congressional Republicans to increased spending.”
Given these reasons it is highly unlikely that Larry Summers would have been able to do anything dramatically different from what the Bernanke led Federal Reserve is currently doing or from what the Yellen led Federal Reserve(which is how it seems like right now) might do in the days to come. As Fridson writes on “My point is rather that the range of policy options will be limited for whoever steps into Ben Bernanke’s shoes. 
Barack Obama was never going to nominate a Fed chairman who would diverge from the narrow list of realistic choices regarding interest rates.”
(Vivek Kaul is a writer. He tweets @kaul_vivek)