Inflation and negative real interest rates- What’s happening?

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Inflation and negative real interest rates- What’s happening?

Dating back to when I was in high school and was taught how fed rates are quintessential instruments in monitoring liquidity and controlling inflation, I used to always wonder how these factors are interlinked and drive a trillion-dollar economy. Fast forward to today, with post covid recovery kicking in and extreme shortages surfacing as a result of the Russian invasion, looks like these economic trends are not just as simple and carry more meaning to them than I had interpreted.

Over the top prices, rising interest rates, and oil shortages, what’s next? Breaking down the scenario into three parts, in this piece I have analyzed what is really happening (with major focus on the Indian economy). The first factor that’s driving everything from my viewpoint is demand- with the Omicron wave behind us and economic activity regaining its momentum, we see manufacturing and trade are resuming to pre covid levels. All industries are experiencing high volumes in business again. Retail outlets, flights, hotels, restaurants, name it and it's sold out. This is an indication of high demand. The other side of the story intends to look at the supply side. The Russian invasion has disrupted the supply chain for countries worldwide. Oil and gas form a sturdy base upon which thousands of industries rely. Domestic and commercial budgets are excessively skewed as a result of supply shortages. With China under strict lockdown, supply has been disturbed from that end as well. When demand surpasses supply, prices inevitably shoot up giving rise to this situation we call Inflation.

The inflation rate in India is hovering around 6.5% at this point. If forecasts are to be believed, industry experts are expecting this to cross 7% this quarter. Who is responsible for fixing this? Well, the Fed (RBI in case of India) possesses the instruments to monitor liquidity within the economy. By increasing the Repo rate, the RBI is looking at reducing the liquidity level and consequently arresting inflation. By increasing the repo rate, you are basically attacking the borrowing incentives and enhancing saving incentives. The purchasing power is what’s primarily targeted.

So, what happens when the Repo rate is lower than inflation? The RBI last week increased the repo rate by 40 basis points to 4.40% in India. With inflation at roughly 6.5%, we are witnessing what is called negative real interest rates. Real interest rates are inflation-adjusted interest rate figures. So if we remove the impact of inflation from this number, we precisely see a negative real interest rate. The calculations show, that the real interest is at roughly -1.97% This translates to borrowers gaining 1.97% on every dollar they borrow! Economic theories explain, that when the real interest rates are high, the income is used towards saving more than consumption. Conversely, when the real interest rate is low, income is used towards consumption more than savings. This in turn again adds to the demand pressure.

Analysts predict this to only be the beginning of a rising interest regime. Even if inflation normalizes marginally to say 5.5%, the repo rate should at least be hovering around 6% for the given term. That said, no freebies for guessing what trajectory can be expected for the repo rates in the coming months and quarters. Morgan Stanley recently forecasted a terminal policy rate at 6.5% (keeping in a margin of at least 100bp from a normalized inflation figure).

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