Inflation conundrum

Okay, let’s start from basic definition of inflation which is increase in the prices of goods due to reasons such as high demand (which is demand-pull inflation), due to some supply constraints or increase in the resource cost (cost-push inflation) and inflation caused by some past events whose effects are still felt (hangover inflation). Inflation is also defined as too much money chasing too few goods. What it certainly means and what many people fail to see is that inflation is a monetary phenomenon.

Yes, I say it again; inflation is a monetary phenomenon which can entirely be controlled by manipulating the money supply in the market, as most central bankers in the world are busy doing these days. One of my friend argued that, if it is that simple then how would you explain that flood in Indonesian mines leads to increase in coal prices or something like even during the period when the money supply is constant, prices of goods continues going up? Well this post will try to answer just these questions.

Let’s take a simple example of a country with only three residents Amar, Akbar and Anthony. Every month Amar purchases some amount of coal from Akbar and rice from Anthony. He pays Rs.50 each for one kg of both items. One particular month, there’s not been much rain, so rice crop was not that great. So Anthony has to put some extra efforts to grow one kg of rice to sell to Amar. When Amar came to purchase rice from Anthony, he saw a sign board with a sign of "Rice – Rs.100/kg" at his shop. He was little disappointed as he had only Rs.100 in the pocket and he was also suppose to purchase one kg of coal from Akbar. So what should this poor guy do?

There are two ways this guy can go; either he purchase ½ kg of rice and 1 kg of coal or he may buy some more rice and cut a slack on amount of coal. In either case, the amount spend by Amar would sum up to Rs.100 only (considering he can go nowhere to borrow); only thing that will be affected will be demand for rice and maybe for coal, depending upon the priority of Amar, the buyer. That’s from the Amar's part, what about Akbar and Anthony who are left with extra rice and coal in their shop and no buyers. With no other options and buyers, they will sell the stuff at lower prices depending upon the demand, which in first case will be Rs.50/kg for one kg of both items (ideal case, of course). So, when Amar calculate his monthly expenditure, it still is Rs.100, so inflation for Amar is 0%. So, any change in demand and supply equation (supply shocks etc.) of the commodity did not have any effect on the prices in the case of constant money supply.

Now imagine that there is a banker, who is ready to provide Amar extra money, let’s say Rs.50 to purchase rice, what will happen then? Well, Amar is going to use that money in addition to the money he has, to buy one kg of rice at Rs.100 and coal at Rs.50 from Akbar and Anthony respectively. Now if you compare Amar’s commodity price basket, you may well comment that total expenditure for same quantity of goods has increased from Rs.100 to 150, an increase of Rs. 50 from previous month i.e. 50% inflation rate!

This inflation would not have been there, if there was no other source of liquidity available to this country. This change in price level has got nothing to do with the supply and demand of rice and coal but with the supply and demand of money. How much money is flowing in the market is actually the one and only determiner of inflation rate experienced by everyone. There might be few supply and demand shocks that may change the prices to drastic levels but that will be for short term as consumers will adjusts their portfolios to accommodate these changes. In the long run, it is the supply and demand of money which decided the inflation rate. As the central banker keeps on printing money, there will be more money available in the market which will lead to decline in the value of money which further will lead to every other good look expensive relative to the money.

Indices to watch out for!!

Here are few graphs which confirms the view that all’s not well with the global economy and we are still a long way off to come out of the grips of bear markets.

The first graph is plot of VIX (volatility index) which is also known as “fear index” as it indicates how far markets (esp. S&P 500) are from stability. Higher values shows that investors are expecting higher volatility (which translates into less stability) in coming future.

VIX has historically traded around 15-20 levels. But, in wake of recent financial turmoil, it has touched new highs of 80. More about VIX here and here.

The other graph indicates confidence in the commercial lending system of the economy. The indicator known as TED Spread is the difference between 3 month T-Bills interest rate and LIBOR. Increasing values indicate increase in counterparty risk which means banks are feeling uneasy about lending to each other which leads to increase in cost of borrowings.

TED has crossed the level of 4% after remaining in the range of 10-50 bps historically.

The above two graphs illustrates the problems faced by financial economy in general, but the last graph show a trend which speaks volumes about slowdown in real economy and aggravates the fear of recession. Baltic Dry Index as it is called indicated the level of trade done globally through the sea-route. Unlike stock market, it is free of any speculative biases. As Wikipedia puts it

“Most directly, the index measures the demand for shipping capacity versus the supply of dry bulk carriers. However, since the demand for shipping varies with the amount of cargo that is being traded in the market (supply and demand) and the supply of ships is much less elastic than the demand for them, the index indirectly measures global supply and demand for the commodities shipped aboard dry bulk carriers, such as cement, coal and grain.”

BDI is trading at 1500 levels after touching all time highs to 11,793 in may 2008. For more information on BDI, see here and here.

Middle of Nowhere

We are living in interesting times. It is not long before stock markets were touching new peaks, everyone was in the race of predicting new sensex highs of 25,000, 30,000 by mid-2008. And then evil of Subprime Crisis raised its head. Earlier, everyone was talking about how decoupled our Indian markets are from those in the west and how India will stay unaffected by the problems of west. How wrong they have been proved? As I write this post, sensex and nifty both have lost the gains they have made during the 2007 bull run.

Current credit crisis has shown that how far we were from reality. Nobody has been left untouched. Markets around the globe reacted badly and posted major losses since the beginning of this year.

With major movers and shakers being history now and humbling of those left, and what experts have already started calling it "End of Wall Street", see here, here and here,

maybe we'll see rise of new financial world order.

They say, "House always win". As we see curtain drawing on wall street circus, we will be closely following the events and preparing ourselves for what may be the next and even bigger "House", apparently a rigged one.