Archive | April, 2009

Liquidity Trap: Revisited

28 Apr

I had touched on the concept of liquidity trap in my previous few posts. I am revisiting the concept here in this small post for the benefit of those who might not still be clear about it. Look at the graph below.


It basically plots the benchmark interest rate set by the major cental bankers against time. What do you see? The benchmark interest rates for US has hit the zero lower bound while for UK and EU, they are very close to zero. Obviously, interest rates cannot turn negative. Now look at the graph below-


The inflation rate in the US has turned negative at -0.38 per cent for the month of March 2009 after a continued and sharp fall since July 2008. Let us compute the real interest rate in March 2009 for the US, which is defined as nominal interest rate minus inflation-

Real Interest Rate = 0.00 – (-0.38) = 0.38 per cent

Definitely low by any standards. However, consider what the real interest rate would have been if the inflation was something like 3.85 per cent (the average inflation rate in the US for the year 2008),

Real Interest Rate = o.oo – 3.85 = -3.85 per cent

Yes, a negative real rate of interest, which would have offered a much larger boost to the economy and given greater traction to the monetray policy operations of the Federal Reserve. As the economy heads deeper into deflation, even with the benchmark interest rates kept at zero, the real rate of interest, reflecting the acutal cost of borrowing, will keep on rising. The above situation is referred to as a liquidity trap and it is easy to see that the monetray policy becomes completely ineffective in influencing the economy, with fiscal policy being the only tool in the hand of the government to bring the economy out of a recession.

Published by: Ravi Saraogi


India far from a Deflationary Spiral

23 Apr


From an inflation scare to a deflation scare, the wheel has come full circle. While the first half of 2008 was spent speculating how high inflation would go, the second half was spent wondering how low inflation would reach, and now, we are all spooked about the possibility of a deflationary spiral. The inflation, which peaked at 12.91 per cent in the second week of August 2008, has been declining since then at a rather alarming pace, plunging to 0.26 per cent in the second week of March 2009, before recovering a little to 0.30 percent in the third week of March 2009.wpi1

Source: Office of the Economic Adviser, Ministry of Commerce and Industry 

Deflation is much feared in the developed world, as falling prices can quickly grow into a deflationary spiral. A deflationary spiral refers to a condition in which prices fall on account of low aggregate demand, and consumers, anticipating a further fall in prices, delay their consumption, leading to an additional fall in aggregate demand and another level of price reductions. A deflationary spiral also leads to excess capacity and a fall in investments. As was seen during the Great Depression of the 1930s, the problem of falling prices, if not checked, can cause an economy to slide into an extended phase of widespread recession.

 A deflationary spiral is also feared because it can cause an economy to fall in a ‘liquidity trap’, in which, aggregate demand and investment remain low even though the nominal interest rate is near zero. This is because in a ‘liquidity trap’, though the nominal rates of interest are lowered by the central bank, the real interest rates remain high on account of falling prices. Real interest rate is obtained by subtracting from the nominal interest rate, the ongoing rate of inflation. For e.g, let the nominal interest rate in the economy be 2 per cent p.a. Now, if the rate of inflation in the economy is 1 per cent, the real interest rate works out to be a paltry 1 per cent p.a. If however, the economy is going through a deflation of 1 per cent (i.e., an inflation rate of negative 1 per cent), the real interest rate works out to be 3 per cent p.a., which is a lot higher than that for the inflationary economy.

 An economy caught in the vortex of a liquidity trap will find itself incapable of conducting monetary policy operations as further lowering of nominal interest rates when they are already near the zero-lower bound is not possible. Getting out of a liquidity trap involves managing inflationary expectations in an economy, which can be difficult as the Japanese case would suggest, which kept its policy rates close to zero for most of 1990s, trying to break from a liquidity trap like condition.

Should India be worried? Several factors suggest that the Indian economy is in no immediate danger of a deflationary spiral and its negative effects. What India is going through at the present is more of disinflation rather than deflation. While deflation is defined as negative growth in prices (inflation based on WPI, though near zero, has not turned negative yet), disinflation refers to a continued fall in the rate of inflation.

Moreover, even if WPI inflation is expected to turn negative in months ahead, inflation based on Consumer Price Index (CPI) for industrial workers, the most widely tracked CPI index, was still at double digit level for the month of Jan 2009 (CPI is computed every month, as opposed to WPI, which is a weekly series) at 10.44 per cent, showing a little dip to 9.6 per cent only in February 2009. The CPI data for the month of March 2009 will be released on 30th April and before that, it is too early to say whether the dip in February 2009 will be continued. cpi1

 Source: Labour Bureau, Government of India 

India is also far from the scare of a liquidity trap as the RBI has enough room to cut policy rates in order to lower borrowing cost in the economy. The repo rate (the rate at which the central bank lends) presently stands at 5 per cent and the reverse repo (the rate at which funds can be parked with the RBI) at 3.5 per cent. The cash reserve ratio stands at 5 per cent. Thus the key policy rates have still a long way to go before they hit the zero lower bound constraint where the monetary policy becomes ineffective. 

Thus, the Indian economy, which is expected to grow at over 5 per cent this fiscal, is far from a deflationary spiral. What the current fall in inflation does is offer room to the RBI to further decrease key policy rates in order to lower lending rates in the economy. Such a move would not only give a monetary push to the economy but will also lay to rest any danger of a deflationary spiral in the future.

Published by: Ravi Saraogi