Will Rajan do a Volcker before 2014 Lok Sabha elections?

 ARTS RAJANVivek Kaul
People who follow the Reserve Bank of India(RBI) governor Raghuram Rajan were expecting him to raise the repo rate by 25 basis points(one basis point is one hundredth of a percentage) in the mid quarter monetary policy review announced on December 18, 2013. Repo rate is the rate at which RBI lends to banks.
But that did not happen. This led one journalist attending the press conference after the policy announcement, to quip “We were expecting a Volcker, we got a Yellen.” To this, governor Rajan replied “Why a Volcker or a Yellen, how about a Rajan?” (As reported 
in the Business Standard).
Rajan took over as the 23
rd governor of the RBI on September 4, 2013. Since then he has often been compared to the former Federal Reserve chairman Paul Volcker.
Volcker took over as the chairman of the Federal Reserve of United States in August 1979. This was an era when the United States had double digit inflation.
Interestingly, when Arthur Burns retired as the Chairman of the Federal Reserve in 1978, the inflation was at 9%. Jimmy Carter, the President of the United States, chose G William Miller, a lawyer from Oklahoma, as the chairman of the Federal Reserve.
Miller had no background in economics. As Neil Irwin writes in 
The Alchemists – Inside the Secret World of Central Bankers “Most significantly, Miller, fearful of a recession, refused to tighten the money supply to fight inflation. By the summer of 1979, with inflation at 10 percent, Carter had had enough. He “promoted” Miller to treasury secretary as a part of the cabinet shake-up, a job with less concrete authority. That left him with a vacancy in the Fed chairmanship.”
Carter picked up Paul Volcker as Miller’s replacement. Volcker at that point of time was the President of the Federal Reserve Bank of New York. Volcker had been a civil servant under four American presidents. “In his meeting with the president before the appointment, Volcker told Carter he was inclined to tighten the money supply to fight inflation. That’s what Carter was looking for – but he almost certainly didn’t understand just what he was getting,” writes Irwin.
In the year that Volcker took over consumer prices rose by 13%. The only way out of this high inflation was to raise interest rates and raise them rapidly. The trouble was that Jimmy Carter was fighting for a re-election in November 1980.
As Irwin writes “On an air force jet en route to an International Monetary Fund conference in Belgrade, Volcker explained his plans to Carter’s economic advisers. They didn’t like them one bit. Sure, Carter wanted lower inflation. But higher interest rates affect the economy with a lag of many months. There was barely a year to go until the president would be running for reelection, which meant that just as their boss was asking voters for another term, unemployment would be sky-rocketing due to the new Volcker policy.”
Volcker was not 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 increasing rates, till they 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, the unemployment rate crossed 10%, the highest it had been since 1940 and nearly 12 million Americans lost their jobs.
During the course of the same year, nearly 66,000 companies filed for bankruptcy, the highest since the Great Depression. And between 1981-83,, the economy lost $570 billion of output. While all this was happening, Jimmy Carter also lost the 1980 presidential elections to Ronald Reagan.
India and Rajan are in a similar situation right now. The consumer price inflation(CPI) for the
 month of November 2013 was at 11.24%. In comparison the number was at 10.17% in October 2013. At the same time Lok Sabha elections are due next year.
In this scenario will Rajan jack up the repo rate to control inflation? When a central bank raises the interest rate the idea is to make borrowing expensive for everyone. At higher interest rates people are likely to borrow less than they were in the past. Also, people are likely to save more money. This ensures that a lesser amount of money chases goods and services, and that in turn brings inflation down.
At higher interest rates, borrowing becomes expensive for the government as well. This might force the government to cut down on its expenses. When a government cuts down on its expenses, a lower amount of money enters the economy, and that also helps in controlling inflation. But that is just one part of the argument.
One school of thought goes that there is not much the RBI can do about inflation by increasing interest rates. Leading this school is finance minister P Chidambaram. As he said in late November “Consumer inflation in India is entrenched due to high food and fuel prices and monetary policy has little impact in curbing these prices…There are no quick fixes for inflation, will take some time to fix it,” he said.
This logic is borne out to some extent if one looks at the inflation numbers in a little more detail. The food inflation as per wholesale price index(WPI) was at 19.93% in November 2013. Within it, onion prices rose by 190.3% and vegetable prices rose by 95.3%. The food inflation as per the consumer price index(CPI) stood at 14.72% in November 2013. Within food inflation, vegetable prices rose by 61.6% and fruit prices rose by 15%, in comparison to November 2012.
Hence, a large part of inflation is being driven by food inflation. As the RBI said in the 
Mid-Quarter Monetary Policy Review: December 2013 statement released on December 18, 2013, “Retail inflation measured by the consumer price index (CPI) has risen unrelentingly through the year so far, pushed up by the unseasonal upturn in vegetable price.”
A major reason behind the Rajan led RBI not raising the repo rate was the fact that they expect vegetable prices to fall. “Vegetable prices seem to be adjusting downwards sharply in certain areas,” it said in the monetary policy review statement. Taimur Baig and Kaushik Das of Deutsche Bank Research in a note dated December 18, 2013, said “vegetable prices, key driver of inflation in recent months, have started falling in the last couple of weeks (daily prices of 10 food items tracked by us are down by about 7% month on month(mom) on an average in the first fortnight of December).”
If vegetable prices in particular and food prices in general do come down then both the consumer price and wholesale price inflation are likely to fall. If we look at the RBI’s decision to not raise the repo rate from this point of view, it looks perfectly fine.
But there is another important data point that one needs to take a look at. And that is core retail inflation. If one excludes food and fuel constituents that make up for around 60% of the consumer price index, the core retail inflation was at 8% in November 2013. This needs to be controlled to rein in inflationary expectations. As the monetary policy review statement of the RBI points out “High inflation…risks entrenching inflation expectations at unacceptably elevated levels, posing a threat to growth and financial stability.”
According to a recent survey of inflationary expectations carried out by the RBI, Indian households expect consumer prices to rise by 13% in 2014. Th rate of inflation that people(individuals, businesses, investors) think will prevail in the future is referred to as inflationary expectation. Inflationary expectations can be reined in to some extent by raising interest rates. As Baig and Das said in a note dated December 16, “RBI would still want to maintain a hawkish stance to ensure that inflation expectations (which is firmly in double digit territory as per recent surveys) do not rise further.”
The trouble here is that higher interest rates will dampen consumer expenditure further. At higher interest rates people are less likely to borrow and spend. The businesses are less likely to expand. This is reflected in the private final consumption expenditure(PFCE) number which is a part of the GDP number measured from the expenditure point of view. The PFCE for the period between July and September 2013 grew by just 2.2%(at 2004-2005 prices) from last year. Between July and September 2012 it had grown by 3.5%. The PFCE currently forms around 59.8% of the GDP when measured from the expenditure side.
The lack of consumer demand is also reflected in the index of industrial production(IIP), a measure of industrial activity. 
For October 2013, IIP fell by 1.8% in comparison to the same period last year. If people are not buying as many things as they used to, there is no point in businesses producing them. It is also reflected in manufactured products inflation, which forms around 65% of WPI. It stood at 2.64% in November 2013.
When the demand is not going up, businesses are not in a position to increase prices. And that is reflected in the manufacturing products inflation of just 2.64%. It was at 5.41% in November 2012.
Given this, if the Rajan led RBI were to keep raising the repo rate to bring down inflationary expectations, it would kill consumer demand further. The Congress led UPA government won’t want anything like this to happen in the months to come. They have already messed up with the economy enough.
Hence, Rajan and the RBI would have to make this tricky decision. If the keep raising the repo rate, chances are they might be able to rein in inflationary expectations and hence inflation, in the time to come. Nevertheless, if they keep doing that the chances of the Congress led UPA in the Lok Sabha elections will go down further.
To conclude, when Arthur Burns was appointed as the chairman of the Federal Reserve on January 30, 1970, president Richard Nixon had remarked,“I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed”. Burns had not disappointed Nixon and started running an easy money policy before the 1972 presidential election, which Nixon eventually won.
Raghuram Rajan needs to decide, whether he wants to go against the government of the day and do what Volcker did, or fall in line and help the government win the next election, like Burns did. Its a tricky choice.

 The article originally appeared on www.firstpost.com on December 20, 2013 
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why the Federal Reserve will be back to full money printing soon

helicash Vivek Kaul 
The Federal Reserve of United States led by Chairman Ben Bernanke has decided to start tapering or go slow on its money printing operations in the days to come.
Currently the Fed prints $85 billion every month. Of this $40 billion are used to buy mortgage backed securities and $45 billion are used to buy American government bonds. Come January and the Fed will ‘taper’ these purchases by $5 billion each. It will buy mortgage backed securities worth $35 billion and $40 billion worth American government bonds, every month. The American central bank hopes to end money printing to buy bonds by sometime late next year.
The Federal Reserve started its third round of money printing(technically referred to as Quantitative Easing(QE)- 3) in September 2012. The idea, as before, was to print money and pump it into the financial system, by buying bonds. This would ensure that there would be enough money going around in the financial system, thus keeping interest rates low and encouraging people to borrow and spend money.
This spending would help businesses and in turn lead to economic growth. With businesses doing well, they would recruit more and thus the job market would improve. Higher spending would also hopefully lead to some inflation. And some inflation would ensure that people buy things now rather than postpone their consumption.
Unlike the previous rounds of money printing, the Federal Reserve had kept QE 3 more open ended. As the Federal Open Market Comittee(FOMC) of the Fed had said in a statement issued on September 13, 2012 “ If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”
Now what did this mean in simple English? Neil Irwin translates the above statement in 
The Alchemists – Inside the Secret World of Central Bankers “We’ll keep pushing money into the system until the job market really starts to improve or inflation starts to become a problem. And we will act on whatever scale we need until we achieve that goal. We’re not going to take the foot off the gas, that is, until some time after the car has reached cruising speed. Markets had been eagerly speculating about the possibility of QE3. Instead, they got something bigger: QE infinity.”
In a statement issued on December 13, 2012, it further clarified that it was targeting an unemployment level of 6.5%, in a period of one to two years. And the hint was that once the level is achieved, the Federal Reserve would start going slow on money printing.
The unemployment rate for November 2013 came in at 7% as employers added nearly 203,000 workers during the course of the month. This is the lowest the unemployment level has been for a while, after achieving a high of 10% in October 2009. The Federal Reserve’s forecast for 2014 is that the rate of unemployment would be anywhere between 6.3 to 6.6%. Given this, it was about time that the Federal Reserve started to go slow on money printing.
History has shown us that continued money printing over a period of time inevitably leads to high inflation and the destruction of the financial system. Hence, going slow on money printing “seems” like a sensible thing to do. But there are several twists in the tail.
The unemployment rate of 7% in November 2013, does not take into account Americans who have dropped out of the workforce, because they could not find a job for a substantial period of time. It also does not take into account people who are working part time even though they have the education and experience to work full time.
Once these factors are taken into account the rate of unemployment shoots up to 13.2%. The labour participation ratio has been shrinking since the start of the finanical crisis. In 2007, 66% of Americans had a job or were looking for one. The number has since shrunk to around 63%. To cut a long story short, all is not well on the employment front.
What about inflation? The measure of inflation that the Federal Reserve likes to look at is the core personal consumption expenditure (CPE). The CPE has been constantly falling since the beginning of 2013. At the beginning of the year it stood at 2%. Since then the number has constantly been falling and for October 2013 stood at 1.11%, having fallen from 1.22% a month earlier. This is well below the Federal Reserve’s target level of 2%. In 2014, the Federal Reserve expects this to be around 1.4-1.6%. And only in 2015 does the Fed expect it touch the target of 2%.
The point is that the Federal Reserve hasn’t been able to create inflation even after all the money that it has printed over the last few years, to keep interest rates low. A possible explanation for this could be the fact that the disposable income has been falling leading to a section of people spending less, and hence, lower inflation. As Gary Dorsch, editor of Global Money Trends newsletter points out in his latest newsletter “For Middle America, real disposable income has declined. The Median household income fell to $51,404 in Feb ‘13, or -5.6% lower than in June ‘09, the month the recovery technically began. The average income of the poorest 20% of households fell -8% to levels last seen in the Reagan era.”
Given this, instead of the inflation going up, it has been falling. The benign inflation might very well be on its way to become a dangerous deflation, feels CLSA strategist Russell Napier.
Deflation is the opposite of inflation, a scenario where prices of goods and services start to fall. And since prices are falling, people postpone their consumption in the hope of getting a better deal at a lower price. This has a huge impact on businesses and hence, the broader economy, with economic growth slowing down.
Deflation also kills stock markets. As Napier wrote in a recent note “Inflation has fallen to 1.1% in the USA and 0.7% in the Eurozone and we are now perilously close to deflation…Investors are cheering the direct impact of QE on their equity valuations, but ignoring its failure to produce sufficient nominal-GDP growth to reduce debt…When US inflation fell below 1% in 1998, 2001-02 and 2008-09, equity investors saw major losses. If a similar deflation shock hits us now, those losses will be exacerbated, since the available monetary responses are much more limited than they were in the past…
We are on the eve of a deflationary shock which will likely reduce equity valuations from very high to very low levels.”
Albert Edwards of Societe Generale in a research note dated December 11, 2013, provides further information on why all is not well with the US economy. As he writes “So far, S&P 500 companies have issued negative guidance 103 times and positive guidance only 9 times. The resulting 11.4 negative to positive guidance ratio is the most negative on record by a wide marginThe highest N/P ratio prior to this quarter was Q1 2001, at 6.8…The margin cycle is turning down, profit forecasts over the next few weeks will be eviscerated. To me, this is consistent with recession.”
What these numbers tell us is that all is not well with the American economy. Over the last few years it has become very clear that the only tool that central banks have had to tackle low growth is to print more money.
Given this, it is more than likely that the Federal Reserve will go back to printing as much as it is currently doing or even more, in the days to come. The FOMC has kept this option open. As it said in a statement “However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchase.”
In simple English, what this means is that if the need be we will go back to doing what we were. As The Economist magazine puts it “It is entirely possible that the tapering decision will prove premature. The Fed terminated two previous rounds of QE, only to restart them when the economy faltered and deflation fears flared. The FOMC’s forecasts have repeatedly proved too optimistic. Two years ago it thought GDP would grow 3.2% in 2013; a year ago, that had dropped to 2.6%, and it now looks to come in around 2.2%..”
We haven’t seen the end of the era of easy money as yet. There is more to come.
The article originally appeared on www.firstpost.com on December 19, 2013.

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

Once more! Fed is blowing bubbles to cover up growing inequality

Bernanke-BubbleVivek Kaul  
The Western central banks(primarily the Federal Reserve of United States and the Bank of England) have been printing money (or quantitative easing as they like to call it) at a very rapid rate since the start of the financial crisis in late 2008. The idea is to print and pump money into the financial system and thus ensure that there is a lot of money going around, leading to low interest rates.
At low interest rates people were expected to borrow and spend more. When they did that businesses would benefit and the economic growth would improve. But this theory hasn’t really worked as well as it was expected to.
The money that was and continues to be printee, has found its way into various financial markets around the world, leading to bubbles and at the same time benefiting those it wasn’t intended to. As Albert Grice of Societe Generale writes in a report titled 
Is the Fed blowing bubbles to cover up growing inequality…again? dated September 27, 2013 “Quantitative Easing(QE) has mainly helped the rich. The Bank of England admitted as much a year ago. Specifically it said that its QE programme had boosted the value of stocks and bonds by 25%, or about $970 billion. It then calculated that about 40 percent of those gains went to the richest 5 percent of British households.”
The situation is similar in the United States as well where the Federal Reserve prints $85 billion every month to keep interest rates low. As Gary Dorsch Editor, Global Money Trends newsletter, 
writes in his later newsletter dated October 3, 2013, “The Fed has always kept its foot pressed firmly on the monetary accelerator, and thus, keeping the speculative juices flowing. Over the past 1-½ years, the Fed has increased the…money supply by +10% to an all-time high of $12-trillion. In turn, traders have bid-up the combined value of NYSE and Nasdaq listed stocks to a record $22-trillion. That’s great news for the Richest-10% of Americans that own 80% of the shares on the stock exchanges.”
Hence, it is safe to say that bubbles across various financial markets have helped the rich get richer, which wasn’t the idea in the first place. Numbers confirm this story. As Emmanuel Saez, of University of California at Berkeley, points out in a note titled 
Striking it Richer: The Evolution of Top Incomes in the United States and dated September 3, 2013 “From 2009 to 2012, average real income per family grew modestly by 6.0%…However, the gains were very uneven. Top 1% incomes grew by 31.4% while bottom 99% incomes grew only by 0.4% from 2009 to 2012. Hence, the top 1% captured 95% of the income gains in the first three years.”
This rise in income inequality might be one reason why the Federal Reserve of United States continues to print money. As Edwards writes “while governments preside over economic policies that make the very rich even richer…the middle classes also need to be thrown a sop to disguise the fact they are not benefiting at all from economic growth.”
So how is the middle class offered a sop in disguise? This is done through an easy money policy of maintaining low interest rates by printing money. In the process, the home prices continue to go up and this ensures that the home owning middle class(which forms a significant portion of both the American and the British population) feels richer.
The S&P/Case-Shiller 20 City Home Index which measures the value of residential real estate in 20 metropolitan areas of the U.S., shows precisely that. 
Overall home price rose by 12.4% in July 2013, in comparison to July 2012. Home prices were up by 27.5% in Las Vegas. They were up 24.8%, 20.8% and 20.4%, in San Francisco, Los Angeles and San Diego, respectively.
A similar scenario seems to be playing out in Great Britain as well. As Edwards wrote in a report titled 
Fools dated September 19, 2013 “Evidence is mounting that easy money …in the UK housing market is leading to another explosion of prices, with London, as always, leading the way with double-digit house price inflation.”
Edwards further points out in another report titled 
If UK Chancellor George Osborne is a moron, Fitch’s Charlene Chu is a heroine dated June 4, 2013, that people have been unable to buy homes despite interest rates being at very low levels because the prices continue to remain very high. As he wrote “Young people today haven’t got a chance of buying a house at a reasonable price, even with rock bottom interest rates. The Nationwide Building Society data shows that the average first time buyer in London is paying over 50% of their take home pay in mortgage payments – and that is when interest rates are close to zero!”
Of course people who already own homes and form a major portion of the population are feeling richer. And thus income inequality is being addressed.
This mistake of propping up housing prices to make the middle class feel rich was one of the major reasons for the real estate bubble in the United States, which burst, before the start of the current financial crisis.
The top 1% of the households accounted for only 7.9% of total American wealth in 1976. This grew to 23.5% of the income by 2007. This was because the incomes of those in the top echelons was growing at a much faster rate.
The rate of growth of income for the period for those in the top 1% was at 4.4% per year. The remaining 99% grew at 0.6% per year. What is even more interesting is the fact that the difference was even more pronounced since the 1990s.
Between 1993 and 2000, the income of the top 1% grew at the rate of 10.3% per year, and the income of the remaining 99% grew at 2.7% per year. Between 2002 and 2007, the income for the top 1% grew at the rate of 10.1% per year. For the remaining it grew at a minuscule 1.3% per year. In fact the wealthiest 0.1% of the population accounted for 2.6% of American wealth in 1976. This had gone up to 12.3% in 2007.
But it was not only the super rich who were getting richer. Even those below them were doing quite well for themselves. In 1976, the top 10% of households earned around 33% of the national income, by 2007 this had reached 50% of the national income.
American politicians addressed this inequality in their own way by making sure that money was available at low interest rates. As Raghuram Rajan writes in 
Fault Lines: How Hidden Fractures Still Threaten the World Economy “Politicians have therefore looked for other ways to improve the lives of their voters. Since the early 1980s, the most seductive answer has been easier credit. In some ways, it is the path of least resistance…Politicians love to have banks expand housing credit, for all credit achieves many goals at the same time. It pushes up house prices, making households feel wealthier, and allows them to finance more consumption. It creates more profits and jobs in the financial sector as well as in real estate brokerage and housing construction. And everything is safe – as safe as houses – at least for a while.”
Of course this is really not a solution to the problem of addressing inequality. It only makes people feel richer for a short period of time till the home prices keep rising and the bubble becomes bigger. But eventually the bubble bursts.
The irony is that people refuse to learn from their mistakes. The same mistake of propping up home prices is being made all over again.

The article originally appeared on www.firstpost.com on October 3, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Decoding Rajan’s Frankfurt speech: Why central banks fuel bubbles

 ARTS RAJANVivek Kaul  
Alan Greenspan, when he was the chairman of the Federal Reserve of United States, the American central bank, used to say “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant.”
Greenspan was known to talk in a very roundabout manner, never meaning what he said, and never saying what he meant. Thankfully, all central bank governors are not like that. There are some who like calling a spade a spade.
Raghuram Rajan, the governor of the Reserve Bank of India(RBI), was in Frankfurt yesterday to receive the 
Fifth Deutsche Bank Prize for Financial Economics. In his speech he said things that would have embarrassed central bank governors of the Western nations, who are busy printing money to get their economies up and running again.
In the aftermath of the financial crisis that started in late 2008, Western central banks have been printing money. 
With so much money going around, the hope is that interest rates will continue to remain low (as they have). At low interest rates people are likely to borrow and spend more. When they do that this is likely to benefit businesses and thus the overall economy.
But what has happened is that the citizens of the countries printing money are still in the process of coming out of one round of borrowing binge. When interest rates were at very low levels in the early 2000s, they had borrowed money to speculate in real estate in the hope that real estate prices will continue to go up perpetually. This eventually led to a real estate bubbles in large parts of the Western world.
Eventually, the bubbles burst and people were left holding the loans they had taken to speculate in real estate. Hence, people who are expected to borrow and spend, are still in the process of repaying their past loans. So, they stayed away from taking on more loans.
But money was available at very low interest rates to be borrowed. Hence, banks and financial institutions borrowed this money at close to zero percent interest rates and invested it in stock, real estate and commodity markets all around the world. Some of this money also seems to have found its way into fancier markets like art. And this has again led to several asset bubbles in different parts of the world. As Rajan put it in Frankfurt “
We seem to be in a situation where we are doomed to inflate bubbles elsewhere.”
Economists still do not agree on what is the best way to ensure
 that there are no real estate or stock market bubbles. But what they do agree on is that keeping interest rates too low for too long isn’t the best way of going about it. It is a sure shot recipe for creating bubbles. Even the once great and now ridiculed “Alan Greenspan” agrees on this. In an article for the Wall Street Journal published in December 2007(after he had retired as the Fed chairman), he wrote “The 1% rate set in mid-2003…lowered interest rates…and may have contributed to the rise in U.S. home prices.”
What he was effectively saying was that by slashing the interest rate to 1%, the Federal Reserve of United States may have played a part in fuelling the real estate bubble in the United States. Rajan in his Frankfurt speech for a change agreed with Greenspan. As he said “
We should wonder whether lower and lower interest rates are in fact part of the problem, I say I don’t know.”
It is easy to conclude from the statements of Greenspan as well Rajan that central bank governors do understand the perils of printing money to keep interest rates low. Given that why are they still continuing to print money? Ben Bernanke, the current Chairman of the Federal Reserve hinted in May 2013, that the Fed plans to go slow on money printing in the months to come. He repeated this in June 2013. But when the Federal Reserve met recently, nothing happened on this front and it decided to continue printing $85 billion every month.
As Albert Edwards of Societe Generale put it in a February 2013 report titled 
Is Mark Carney the Next Alan Greenspa…? I keep seeing Central Bankers saying again and again that QE(quantitative easing, a fancy term for printing money) and more recently, helicopter money is not only necessary but essential.”
So the question is why do central banks in the Western world continue to print money? Dylan Grice, formerly of Societe Generale, has an answer in his 2010 report 
Print Baby Print. As he writes “What’s interesting is that central banks feel they have no choice. It’s not that they’re unaware of the risks…They’re printing money because they’re scared of what might happen if they don’t. This very real political dilemma… It’s like they’re on a train which they know to be heading for a crash, but it is accelerating so rapidly they’re scared to jump off.”
Sometimes the withdraw symptoms are so scary that it just makes sense to continue with the drug. Dylan compares the current situation to the situation that Rudolf von Havenstein found himself in as the President of the Reichsbank, which was the German central bank in the 1920s.
Havenstein printed so much money that it led to hyperinflation and money lost all its value. The increase in money printing did not happen overnight; it had been happening since the First World War started. By the time the war ended, in October 1918, the amount of paper money in the system was four times the money at the beginning of the war. Despite this, prices had risen only by 139%. But by the start of 1920, the situation had reversed. The money in circulation had grown 8.4 times since the start of the war, whereas the wholesale price index had risen nearly 12.4 times. It kept getting worse. By November 1921, circulation had gone up 18 times and prices 34 times. By the end of it all, in November 1923, the circulation of money had gone up 245 billion times. In turn, prices had skyrocketed 1380 billion times since the beginning of the First World War.
So why did Havenstein start and continue to print money? Why did he not stop to print money once its ill-effects started to come out? Liaquat Ahamed has the answer in his book The Lords of Finance. As he writes “were he to refuse to print the money necessary to finance the deficit, he risked causing a sharp rise in interest rates as the government scrambled to borrow from every source. The mass unemployment that would ensue, he believed, would bring on a domestic economic and political crisis.”
The danger for central bank governors is very similar. If they stop printing money then interest rates will start to go up and this will kill whatever little economic growth that has started to return. Hence, the choice is really between the devil and the deep sea.
As far as Rajan is concerned he is possibly back to where it all started for him. The Federal Reserve Bank of Kansas City, one of the twelve Federal Reserve Banks in the United States, organises a symposium at Jackson Hole in the state of Wyoming, every year.
The 2005 conference was to be the last conference attended by Alan Greenspan, as the Chairman of the Federal Reserve. Hence, the theme for the conference was the legacy of the Greenspan era. Rajan was attending the conference and presenting a paper titled “Has Financial Development Made the World Riskier?
Those were the days when Greenspan was god. The United States was in the midst of a huge real estate bubble, but the bubble wasn’t looked upon as a bubble, but a sign of economic prosperity. The prevailing economic view was that the US had entered an era of unmatched economic prosperity and Alan Greenspan was largely responsible for it.
Hence, in the conference, people were supposed to say good things about Greenspan and give him a nice farewell. Rajan spoiled what was meant to be a send off for Greenspan. In his speech Rajan said that the era of easy money would get over soon and would not last forever as the conventional wisdom expected it to. “The bottom line is that banks are certainly not any less risky than the past despite their better capitalization, and may well be riskier. Moreover, banks now bear only the tip of the iceberg of financial sector risks…the interbank market could freeze up, and one could well have a full-blown financial crisis,” said Rajan.
In the last paragraph of his speech Rajan said it is at such times that “excesses typically build up. One source of concern is housing prices that are at elevated levels around the globe.”
He came in for a lot of criticism for his plain-speaking and calling a bubble a bubble. As he later recounted about the experience in his book Fault Lines – How Hidden Fractures Still Threaten the World Economy, “Forecasting at that time did not require tremendous prescience: all I did was connect the dots… I did not, however, foresee the reaction from the normally polite conference audience. I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticized by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself…Rather it was because the critics seemed to be ignoring what going on before their eyes.”
The situation is no different today than it was in 2005, when Rajan said what he did. The central bank governors are ignoring what is going on before their eyes and that is not a good sign. Or as Rajan put it in Frankfurt “When they (central banks) say they are the only game in town, they become the only game in town.”
The article originally appeared on www.firstpost.com on September 27,2013

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

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.
Rajan, 
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 www.firstpost.com on Septmber 21, 2013

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