Inflation expectations

How the American real estate bubble impacts you and your investments

What if I were to say that the home prices in the United States impact the value of your investments in India. You will probably turn around and ask me to go take a walk.

But the fact of the matter is that there is actually a link between the two and we have reached a stage where the link perhaps matters more than it ever did. Nonetheless, before we get into understanding this, it’s important to know how we got here in the first place.

In late 2019 and early 2020, rich world central banks led by the Federal Reserve of the United States, the American central bank, started to print a lot of money, first to take care of the economic slowdown and then the economic contraction because of the spread of the covid pandemic.

The idea was to drive down interest rates. At lower interest rates people were expected to borrow and spend money. Interest rates on thirty year home loans in the United States fell to as low as 2.65% in early January 2021, the lowest they had been since 1971, the year from which this data is available.

Naturally, with interest rates at such low levels, more people started borrowing and buying homes than was the case in the past. While the demand for homes went up quickly, their supply couldn’t go up as quickly to meet this extra demand. Hence, home prices went up, at a very past pace.

In April 2022, home prices in the US, as per the S&P Case-Shiller 20-City Composite Home Price Index, went up by 21.2% in comparison to April 2021. Home prices have been rising at more than 17% year on year from May 2021 onwards. This kind of price rise wasn’t even seen during the real estate bubble of the 2000s.

One straight impact of this has been rising home rents. As per Realtor.com, the median rent in the United States in May 2022 was 23.2% higher than in May 2020 and 15.5% higher than in May 2021. This rise in home rents feeds into retail inflation. As The Economist puts it, in May 2022, the “rising housing costs already accounted for 40% of the monthly increase in the consumer-price index [which measures retail inflation].”

In May 2022, the retail inflation in the United States stood at 8.6%, the highest since December 1981, when it was at 8.9%. People are now building in this high inflation into their monetary calculations; in the home-rents they demand and in the salaries and wages they ask for.

In May 2022, the median one-year ahead expected inflation rate in the United States was 6.6%, the highest that it has been in a while. As any economist would put it, once inflation expectations set in the minds of people it becomes very difficult for central banks to control inflation.

So, in this scenario, it has become very important for the Federal Reserve to control the fast pace at which housing prices have been going up, given that it can’t do much about the high energy prices, due to the war in Ukraine.

The Federal Reserve has decided to gradually withdraw some of the money that it had printed and pumped into the financial system. Between June 2021 and May 2022, it expects to suck out close to a trillion dollars, bringing an era of easy money to an end.

This is already pushing up home loan and other long-term interest rates in the United States. As of June 30, the median interest rate on a 30-year fixed interest rate home loan had risen to 5.7%, from a low of 2.65% in early January 2021.

As the Fed keeps sucking out money, the interest rate on home loans will keep going up and this will hopefully drive down the demand for fresh homes and the rate of price rise of homes. As home price inflation cools down, rental inflation will also cool down and in turn bring down retail inflation. That’s the theory.

Other than taking out the money it had printed, the Federal Reserve also plans to raise its key short interest rate, the federal funds rate. This is expected to drive up short term interest rates in the United States.

The end of the era of easy money and rising interest rates in the United States will have an impact on investments in India. In fact, this is already happening. The foreign institutional investors (FIIs) have already sold Indian stocks worth Rs 2.56 trillion between October 2021 and July 1, 2022. This has led to the value of investments in stocks, equity mutual funds and unit linked insurance plans, falling.

Further, as FIIs sell out of India, they convert their rupees into dollars, leading to a surge in the demand for the dollar and drop in the value of the rupee. One dollar is currently worth around Rs 79. It was worth around Rs 74.5 at the beginning of 2022. This makes life expensive for those looking to study abroad or to go for a foreign holiday.

As the Federal Reserve raises interest rates, the Reserve Bank of India will have to do the same. This will push up interest rates on loans as well as deposits in India. Hence, people with loans are likely to end up paying higher EMIs, whereas people with deposits are likely to earn a higher interest than was the case in the past. Again, this is already happening.

Of course, a big impact of the rise in interest rates in the United States has been on crypto prices, which have crashed by close to 80% from their all-time high-levels, leaving many zoomers poorer.

All in all, as the old cliché goes, when America sneezes, the whole world catches cold.

This piece originally appeared in the Deccan Herald on July 3, 2022, with a different headline.

Why Raghuram Rajan finally cut the repo rate

ARTS RAJANVivek Kaul

“I have never run a full marathon, and my wife will not let me run one…She says that’s tempting fate.” – Raghuram Rajan in an interview to The New York Times

I am not an early riser. These days with no full time job, I rarely wake up before 10 AM. Yesterday was not any different and by the time I woke up, I had already got a few messages on WhatsApp from friends and ex-colleagues informing me that Raghuram Rajan, governor of the Reserve Bank of India (RBI), had finally cut the repo rate.
Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans. Rajan cut the repo rate by 25 basis points(one basis point is one hundredth of a percentage) to 7.75%.
For the past few months there was tremendous political pressure on the governor to cut the repo rate. So what prompted Rajan to finally cut it? “To some extent, lower than expected inflation has been enabled by the sharper than expected decline in prices of vegetables and fruits since September, ebbing price pressures in respect of cereals, and the large fall in international commodity prices, particularly crude oil…Weak demand conditions have also moderated inflation excluding food and fuel, especially in the reading for December,” Rajan said in a statement released early morning yesterday.
The massive crash in crude oil price has contributed to lowering inflation to some extent. But more than that it has helped save precious foreign exchange spent on importing oil. As, Urjit Patel, one of the deputy governors of the Reserve Bank of India (RBI), recently explained “The dramatic fall in oil prices is a boon for us. It saves, on an annualised basis, around US$ 50 billion, roughly, one-third of our annual gross POL (petroleum, oil and lubricants) imports of about US$ 160 billion.”
The fall in the price of crude oil as I have pointed out in the past, has also ensured that the government’s fiscal deficit hasn’t gone totally for a toss. Even with the massive fall in crude oil prices the fiscal deficit for the period April to November 2014 was at 99% of the annual target. Now imagine where the fiscal deficit would have been if this fall in crude oil price had not happened.
On December 2, 2014, the day the Fifth Bi-Monthly Monetary Policy Statement for the last year was released, the Rajan led RBI had kept the repo rate unchanged. The price of the Indian basket of crude oil on December 2, 2014, had stood at $70.08 per barrel. By January 14, 2015, the price of the Indian basket of crude oil had fallen by a massive 38.1% to $43.36 per barrel.
This was a huge change from the time of the last monetary policy statement was released around six weeks back. Clearly, Rajan and the RBI, like almost all other experts, did not see this massive fall in oil price coming.
If that had been the case, the RBI would have cut the repo rate last month itself. As The New York Times reports: “Mr. Rajan also defended his decision not to lower interest rates at his last monetary policy review in December. While oil prices had already fallen considerably by then, he said there was no way to foresee the abrupt plunge that followed.”
The RBI expects the oil prices to continue to remain low. “Crude prices, barring geo-political shocks, are expected to remain low over the year,” the central bank said yesterday.
Another reason which led to the RBI cutting interest rates in between meetings are the falling inflation expectations (or the expectations that consumers have of what future inflation is likely to be).
As per the previous Reserve Bank of India’s Inflation Expectations Survey of Households, the inflationary expectations over the next three months and one year were at 14.6 percent and 16 percent. In the latest inflation expectations survey released yesterday, these numbers have crashed to 8.3% and 8.9% (See chart that follows). “ Households’ inflation expectations have adapted, and both near-term and longer-term inflation expectations have eased to single digits for the first time since September 2009,” Rajan said. This would have been another reason which led the Rajan led RBI to an inter-meeting cut in the repo rate.

Trends in Inflation Perceptions and Expectations

In the statement released on December 2, 2014, RBI had hinted that rate cuts would start in early 2015. “If the current inflation momentum and changes in inflationary expectations continue, and fiscal developments are encouraging, a change in the monetary policy stance is likely early next year, including outside the policy review cycle,” the statement had said.
And that is precisely what the Rajan led RBI has done. It had also said that: “The Reserve Bank has repeatedly indicated that once the monetary policy stance shifts, subsequent policy actions will be consistent with the changed stance.” What this meant in simple English is that once the RBI was convinced that inflation has been brought under control it would cut interest rates rapidly.
Crisil Research expects the RBI to “ cut rates by 50-75 basis points over the next fiscal (i.e. 2015-2016).”
Analysts Chetan Ahya and Upasana Chachra of Morgan Stanley are more bullish. They said in a research note released yesterday: “We believe that this is a beginning of a big rate cut cycle. We expect a further 125bps rate cuts over the next 12 months, cumulative 150bps in this cycle (compared with our earlier forecast of 50bps rate cuts). We expect a further rate cut of 25bps in the next monetary policy review on Feb 3.”
Personally, I don’t think Rajan will cut the repo rate on February 3. He will wait for the government to present the annual budget and then decide further course of action. As he said in yesterday’s statement: “Key to further easing are data that confirm continuing disinflationary pressures.” This means that if inflation keeps falling or remains stable, the RBI will cut the repo rate more in the days to come.
As Crisil Resarch pointed out in a research note yesterday: “Retail inflation has stayed within 5% and core inflation [non food-non fuel inflation] continues to decline. Core inflation fell to 5.5% from 5.8% in November, the lowest recorded since the beginning of the new CPI series in 2012. Current momentum suggests inflation could fall below the RBI’s target of 6% by March 31, 2015. Wholesale price index based inflation (WPI) has hit the rock-bottom, coming at 0% in November and 0.11% in December…In addition, the fall in WPI is accompanied by a mirroring decline in the CPI index, something that was missing in 2009. This points to the sustainability of the current disinflationary trend, and strengthens the case for lower policy rates.”
Nevertheless Rajan also said that “also critical would be sustained high quality fiscal consolidation.” As Crisil Research pointed out: “The speed of the cuts will hinge on continued fiscal consolidation, and measures to improve the potential of the economy so that higher GDP growth does not set off fresh price fires.” And that is something to watch out for.
And to decide whether “fiscal consolidation” is happening Rajan would have to wait for the government to present its budget. Another reason why a rate cut is unlikely on February 3 is that no key economic data points are to be released between now and then.

Postscript: Economist Surjit Bhalla told Reuters yesterday that : “If there is a deal between Rajan and Jaitley, that’s very very positive…Monetary and fiscal policy should be coordinated.” This isn’t the best way to approach the issue, for the simple reason that politicians want interest rates to remain low all the time.
Alan Greenspan, the former chairman of the Federal Reserve of the United States, recounts in his book The Map and the Territory that in his more than 18 years as the Chairman of the Federal Reserve, he did not receive a single request from the US Congress urging the Fed to tighten money supply and thus not run an easy money policy.
In simple English, what Greenspan means is that the American politicians always wanted low interest rates. India is no different on that front. The current finance minister Arun Jaitley has made several comments in the recent past asking the RBI to cut the repo rate. The previous finance minister P. Chidambaram was no different.
To conclude, it is well worth remembering here what  economist Stephen D King writes in When the Money Runs Out “A central banker who jumps into bed with a finance minister too often ends up with a nasty dose of hyperinflation.”

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 16, 2015