By Balkrushna Vaghasia and Mrunal Shah
"Inflation is taxation without legislation" - Milton Friedman
Food inflation was 5.01% in May 2021. Overall Consumer Price Inflation (CPI) was at 6.30% Y-o-Y and Weighted Price Inflation (WPI) was at 12.94% Y-o-Y. Prices of major edible oil have increased ranging from 28% to 60% from March 2020 to June 2021. Automobile companies are about to increase the prices of vehicles from 10% to 15%. Crude oil, Steel, Copper, Aluminium, Lumber, Lithium (so called battery metal), coffee, corn, food grains, you name it and their prices would have skyrocketed. Primary commodity prices have increased by 9.61% in May 2021 from a year before. Let’s begin from the beginning of March 2020. The WHO recognized the of covid-19 as a pandemic on 11 March 2020. In the following fortnight, financial markets crashed in the range of 20% to 50%. All the countries closed their international borders for 3-4 months. A lot of companies laid off their employees. Afterwards, countries started opening for mobility in a manner from July 2020. Then several waves of infections hit at an interval of 4-6 months in many countries. During the same time inflation reached a record. Given that you are aware that there are reasons for this record breaking inflation, let us have a look at ours.
Bond Buying Program by Central Banks around the World.
As a part of monetary policy in the period of crisis, central banks purchase assets from open markets in order to provide liquidity when there is a risk of fallout in financial markets. Among many assets, government treasury bonds and mortgage-backed bonds are the most common assets which central banks usually buy from the open market. Leading the pack, the US Federal has bought Treasury Bonds worth around $2.6 Trillions. Our own RBI has bought Rs. 4,47,132 Crore Government Treasury Bonds of various maturities from March 2020. In fact, the RBI has bought so much of 10-year paper that it has now dropped from the most traded paper to 6th most traded paper in India. By open market purchase of treasury bonds, RBI has flooded the economy with a tremendous amount of liquidity, leaving a lot of cash unemployed. This large pool of money had to find a new home in order to avoid opportunity cost.
Lowest Interest Rates EVER seen
Another tool of RBI to stimulate the economy is interest rates at which it lends money to banks, otherwise known as repo-rate. RBI gradually reduced the repo rate from 5.40% in August 2019 to 4% in May 2020, the lowest in the history. Afterwards, no change has been made in the repo-rate of 4%. Not only RBI, almost all central banks around the world have reduced repo rate to a record low, making available money at cheap rate to the borrowers. While many companies have taken the benefit of record low interest rates, the important
aspect is where this cheap money has been used. Major corporations have taken the benefit of lower interest rates by refinancing their existing debts, instead of making capital expenditure on new projects, which in turn can create a lot of jobs directly and indirectly. This tendency among corporations has defeated the RBI’s purpose in lowering interest rates. Also, a lot of cheap money has gone into speculation, finding its place in the securities and commodity market. Had this cheap money been deployed to a greater extent in productive resources, a greater employment and demand would have been generated. A great pool of money is chasing limited assets, bidding prices to sky high.
Fiscal stimulus by Central Governments around the World
In order to prevent the collapse of the economies by stimulating the demand, the federal governments have provided fiscal assistance in various forms. The Indian Government has provided a fiscal stimulus of $ 228 billion from January 2020 till April 2021, which is more than 8.5% of the Indian GDP. The US Federal Government has provided stimulus of $ 5.8 trillion in various forms. In total, the Federal Governments around the world have provided a fiscal stimulus of more than $ 16 Trillion, which is close to 19% of the World GDP. As people got free money, especially in developed nations, the demand for products spiked immediately after the easing of lockdowns, causing imbalance in demand-supply parity. Rampant speculation in securities and commodities markets
With almost 3-6 months of idleness of a vast young population around the world has resulted in a new trend. A so-called lack of financial literacy has afflicted today’s youth. A lot of people have started trading (I would rather say speculating) in equity, commodities, currencies (and of course crypto currencies), metals, food grains, you name it and there they are. Recently, Chinese Government has asked brokers in the market not to book orders for retail traders. Also, it has started releasing Steel reserves to cool down steel prices. Overall, this market wide speculation has caused prices to soar at record levels.
Mismatch of demand and supply in the labor market globally.
Because of the initial demand shock in various industries in Q1 of FY 2021, a lot of enterprises laid off employees, especially companies which require physical presence of consumers. Now there is an uneven demand because of localised lockdowns. As a result, there is a frequent mismatch in demand and supply over a year and half. Because of the unstable demand, the supply chain is not functioning in a linear chain. Unlike the inflation of 1995 to 1998 caused by high demand, the current inflation is more supply shortage driven than the demand driven.
Ship Container shortage Localised lockdowns are being implemented across the world as the corona crisis is evolving in various regions. There is a sudden rise and fall in demand intermittently. As a result, the business owners are not able to predict the demand trends for their goods and services. This volatility in demand is putting pressure on the supply chain, especially supply of ship containers.
As the passenger flights are getting cancelled, the demand for shipping has increased. China was recently exporting 3 containers for each container imported, causing pile up of containers in western continents of the world. Further, containers are being quarantined at ports. Covid- 19 pandemic has caused a significant shift from service consumption to goods consumption because of nationalised lockdowns.
All these events have caused the increase in turnaround time of containers from 60 days to 100 days. The cost of international shipping has increased more than 100% in the last one year.
Decision of OPEC+ to curtail the production of crude oil.
One of the key factors appearing as a cause of inflation around the world over the last five decades, crude oil is also present this time, though coming late to the party. Economic sanctions on Iran in 2019 and Russia in 2020 by the USA also reduced the supply of crude oil in the world markets. Before sanctions, Iran supplied 10% of annual crude oil demand of India. These events led to a surge in crude oil prices to $74 per barrel from $22.74 per barrel in March 2020. As a result, Petrol and diesel prices are hovering around Rs100 per litre, causing a noticeable increase in cost of all goods and services.
What is our view of the future?
We see 2-3 more waves in the next 2 years. Each wave is less severe than the previous one, owing to increased vaccination rate and herd immunity. This will bring disruption in supply, with lower disruption in each succeeding event. Each disruption will cause the volatility in supply. As a result, there will not be a consistent demand and supply parity. We believe that supply will keep fluctuating, with a declining impact of each disruption. In essence, we estimate the inflation to be in the tolerance band of RBI in the second half of F.Y. 2023. Though some of the central bankers (Russian, Brazil, etc.) have started increasing policy repo rates, central bankers from mature and /or bigger economies have not yet taken any step in reducing liquidity from the market, focusing more on growth at this stage. Sooner or later RBI will increase the repo-rate and pull the excess liquidity, bringing the inflation within the tolerance band.