Monthly Archives: July 2010

India Aggressively Raises Rates to Battle Inflation

Posted on July 27, 2010 by | 2 Comments

The Reserve Bank of India (RBI) has increased the reverse repo rate, the rate at which the central bank absorbs excess cash, by 50 basis points to 4.5 percent, surprising markets that had expected a 25 basis point rise. In line with most forecasts, the RBI also raised the repo rate, the rate at which it lends to commercial banks, by 25 basis points to 5.75 percent.  The move is focused on reigning in inflation, which has risen at double-digit rates for five months.

“The dominant concern that has shaped the monetary policy stance in this review is high inflation,” the central bank said in a statement. “With growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation and anchoring inflationary expectations.”  The RBI’s hope is to bring inflation down to a 6 percent annual growth rate by early 2011.

While the RBI revised its GDP growth outlook for 2010-11 to 8.5 percent from 8.0 percent, the central bank noted its concern “that if the global recovery falters, the performance of emerging market economies is likely to be adversely affected, and a widespread slowdown in global trade will have an impact on the Indian manufacturing and service sectors too.” Local Indian business groups have warned against moves to raise rates on concern that the reduced liquidity would hurt India’s fast-growing economy.

The press release from the RBI is reproduced below:

First Quarter Review of Monetary Policy 2010-11: Press Statement by Dr. D. Subbarao, Governor

“This morning, the Reserve Bank released the First Quarter Review of Monetary Policy for 2010-11 at a meeting of the chief executives of major banks. The important decisions contained in the review were to raise the repo rate from 5.5 per cent to 5.75 per cent and the reverse repo rate from 4 per cent to 4.50 per cent.  This asymmetric raise in rates narrows the LAF corridor from 150 basis points to 125 basis points.

Balance of Policy Stance

2.   The dominant concern that has shaped the monetary policy stance in this review is high inflation. Even as food price inflation and, more generally, consumer price inflation, have shown some moderation, they are still in double digits. Non-food inflation has risen, and demand side pressures are clearly evident. With growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation and anchoring inflationary expectations.

Global Outlook

3.  Since our last policy review in April, the macroeconomic environment has changed significantly. In the aftermath of the Greek sovereign debt crisis and other visible soft spots in Europe and the US, there is renewed uncertainty about the sustainability of the recovery. In contrast, EMEs are witnessing strong growth, driven by rising domestic demand, restocking of inventories and, thus far, recovering global trade. The relatively rapid recovery in EMEs has also been accompanied by higher inflation. Overall, though, there is widespread expectation of a slowdown of the global economy in the second half of 2010.

Indian Economy

Growth

4.  The macroeconomic developments in India are contrarian to the global trend. We have recovered faster, but our inflation rate has also been higher. The recovery process has consolidated and become more broad-based since April 2010. A big ‘known unknown’ in April 2010 was the outlook on monsoon. That has since become a ‘known known’ in the sense that rainfall so far has been better than during last year, and the crop-wise area sown and the distribution of rainfall offer scope for cautious optimism on the agricultural front.

5.  Better farm sector prospects should lead to a pick-up in rural demand. This should give further momentum to the performance of the industrial sector which has been growing firmly. The strength of the recovery is also reflected in the sales and profitability growth of the corporate sector with more investment intentions being translated into action across a range of sectors. While domestic drivers of growth are robust, any slowdown in the global recovery will affect all EMEs, including India.

6.  Taking into account the above factors, the projection for real GDP growth for 2010-11 is revised to 8.5 per cent, up from our April policy projection of 8.0 per cent with an upside bias. This upward revision is primarily based on better industrial production and its favourable impact on the services sector while giving due consideration to the global scenario.

Inflation

7.  The developments on the inflation front are, however, worrisome. Let me explain. WPI inflation has been in double digits since February 2010. Primary food articles inflation, despite some moderation, continues to be in double digits. Between November 2009 and June 2010, non-food inflation rose from zero to 10.6 per cent and non-food manufactured inflation from zero to 7.3 per cent. Significantly, non-food items contributed over 70 per cent to WPI inflation in June 2010, suggesting that inflation is now very much generalised. Inflation in terms of all four consumer price indices remains in double digits notwithstanding some decline in recent months.

8.  Going forward, the outlook on inflation will be shaped by: (i) the monsoon performance for the remaining period; (ii) movements in global energy and commodity prices, which have been showing distinct signs of softening over the past few weeks; and (iii) potential build-up in demand-side pressures with the strengthening of domestic growth drivers.

9.  Taking into account the emerging domestic and external scenario, the baseline projection for WPI inflation for March 2011 has been raised to 6.0 per cent from our April policy projection of 5.5 per cent.

Monetary Aggregates

10. It is expected that even with the higher growth projection, monetary aggregates will evolve along the projected trajectory indicated in the April policy statement. Accordingly, for policy purposes, we have retained the earlier projections of money supply (M3) at 17 per cent and of non-food bank credit growth at 20 per cent.

Risk Factors

11.  Let me indicate some important risks to the growth and inflation outlook.

  • The first risk factor is that if the global recovery falters, the performance of EMEs is likely to be adversely affected, and a widespread slowdown in global trade will have an impact on the Indian manufacturing and service sectors too.
  • The second risk factor is that an uncertain global situation will  significantly reduce the flow of capital into EMEs. Such a slowdown in capital inflows will constrain domestic investment which is critical to achieving and sustaining high growth rates. This could potentially be a problem in India too since our rapid recovery has resulted in a widening of the current account deficit.
  • It must be recognised though that the risk of capital flows runs both ways. It is quite possible that EMEs, including India, will receive more flows than they need because of accommodative monetary policies of advanced country central banks for an extended period. Large capital inflows above the absorptive capacity of our economy will pose a challenge for monetary and exchange rate management, and also have implications for asset prices. In this scenario, a widening current account deficit will help absorb a larger proportion of the inflows.
  • The third risk factor is on the inflation front.  Softening of inflation in the months ahead is contingent on moderation of food prices which in turn will depend on a balanced spatial andtemporal distribution of rainfall in the remaining period of this monsoon season.
  • While on risk factors, we must note one important upside.  If global growth does not pick up, commodity and energy prices will remain subdued.  Furthermore, unutilised global capacity in several sectors will soften the prices of imports and put downward pressure on import substitutes.

Monetary Policy Stance

12. The Reserve Bank began the reversal of its expansionary monetary policy in October 2009 and has calibrated the exit to India’s specific growth-inflation dynamics. Today’s policy action in particular has been informed by three major considerations:

(i) domestic economic recovery is firmly in place and is strengthening;

(ii) there is a need to contain the demand-side inflationary pressures which are clearly evident; and

(iii) despite the increase in the policy rates by 75 basis points cumulatively, it is imperative that we continue in the direction of normalising our policy instruments to a level consistent with the evolving growth and inflation scenario, while taking care not to disrupt the recovery.

13. Our monetary policy actions are expected to:

i) Moderate inflation by reining in demand pressures and inflationary expectations.

ii) Maintain financial conditions conducive to sustaining growth.

iii) Generate liquidity conditions consistent with more effective transmission of policy actions.

iv) Restrict the volatility of short-term rates to a narrower corridor.

Operating Procedures of Monetary Policy

14.  Now let me turn to two new initiatives – one structural and the other on policy review and communication.

15.  The Reserve Bank’s LAF operates in such a manner that as systemic liquidity alternates between surplus and deficit, even at the margin, the overnight call money rate alternates between the reverse repo rate and the repo rate. As the systemic liquidity transits from a uni-directional surplus mode to a bi-directional mode, it will have implications for the effectiveness of monetary transmission. In the context of the changing liquidity dynamics, the operation of the LAF needs to be studied.  Accordingly, it is proposed to set up a Working Group to review the current operating procedure of monetary policy of the Reserve Bank, including the LAF.

Mid-Quarter Review of Monetary Policy

16. The second new initiative relates to a more frequent policy review. While our scheduled policy announcements are quarterly, in recent years, there have been several occasions, including March and July 2010, when we had to take off-cycle monetary policy actions. One significant advantage of the quarterly schedule is that it allows us to bring the full range of inputs into the decision-making process. Nevertheless, in a rapidly evolving macroeconomic situation, we need to combine the rigour and comprehensiveness of the quarterly process with the responsiveness and flexibility of more frequent reviews. Accordingly, the Reserve Bank will now undertake mid-quarter reviews roughly at the interval of about one and half months after each quarterly review. As per schedule, mid-quarter reviews will be in June, September, December and March.  They will be by way of a press release and will communicate our assessment of economic conditions more frequently, and will provide a rationale for either policy action or maintenance of the status quo. However, the Reserve Bank will have the flexibility, as always, to take swift and pre-emptive policy action, as and when warranted by the evolving macroeconomic developments.

Discussions with Banks

17. Banks welcomed the Reserve Bank’s policy stance. They agreed that the monetary measures announced by the Reserve Bank today were appropriate in light of the current global and domestic balance.  They also indicated that credit growth has picked up, though it is yet to become broad-based. Apart from monetary measures, discussions with banks focused on four specific issues viz., (i) liquidity situation and the liquidity adjustment facility (LAF) corridor; (ii) Basel III norms; (iii) credit flows to micro, small and medium enterprises (MSMEs); and (iv) base rate. Banks indicated that the liquidity situation may remain tight for some more time as deposit growth has lagged behind the credit growth. They felt that a narrower LAF corridor will restrict short-term interest rate volatility and improve monetary transmission. Banks mentioned that the impact of Basel III norms on Indian banks will not be significant.  However, statutory liquidity ratio (SLR) assets need to be included in the liquidity coverage ratio. Credit portfolio in respect of MSMEs sector of many banks is growing at a rapid rate.  The Reserve Bank emphasised that the pace of credit expansion to MSMEs should be sustained and banks should sensitise the frontline managers the importance of lending to MSMEs. Banks indicated that the transition to the base rate has been generally smooth, though there are issues relating to the existing loans.”

G. Raghuraj
Deputy General Manager

Press Release : 2010-2011/140

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Posted in Central Banks, Economy, India, Reserve Bank of India

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High-Yield Debt Defaults at Incredible 1 Percent Pace in 2010

Posted on July 27, 2010 by | Leave a comment

For the first five months of 2010, there have been just nine high-yield debt issuer defaults, representing an annual pace of defaults of just 1 percent, according to a report by Fitch Ratings.  The nine defaults affected a total of $1.7 billion of bonds.  Compare that to the 151 issuer defaults in 2009 that affected a record combined $118.6 in bonds, and the difference is astonishing.  The default rate in 2009 was 13.7 percent.

The report by Fitch Ratings examines the reasons why high-yield corporate defaults have all but disappeared, and why this stunning reversal does not necessarily portend that happy days are here again.  If nothing else, the data prove that high-yield corporate debt issuers are perhaps more sensitive than any other investment arena to macroeconomic and capital market developments.  Thus, the recent Eurozone debt crisis and questions about the sustainability of the economic recovery through 2011 and 2012, without the aid of heavy doses of government stimulus, may negatively affect high-yield bonds.

Still, the dramatically low 2010 default rate is remarkable, and has been produced by several factors.  These ranged from a marked decline in downgrades, to far improved bond market conditions, to the unprecedented quick action by U.S. companies to cut costs, shore up balance sheets, and boost liquidity in response to fears of a prolonged period of sluggish growth. All of these developments had and were expected to continue to put downward pressure on the default rate.

Fitch had forecast a default rate for 2010 of 6−7 percent, well below 2009’s 13.7 percent, but still elevated on a historical basis. With the 2010 default rate running significantly below this, Fitch estimates that the economy’s better than expected performance, especially on the consumer spending side, accounts for roughly half the variance between Fitch’s forecast and the pace of defaults this year. In years when the U.S. high yield default rate has run below 2 percent, U.S. GDP growth has averaged 3.5 percent. Fitch’s forecast, developed late in 2009, assumed weaker growth for 2010, on the order of 2 percent. Even so the 1 percent run rate is by all accounts extremely low.

To view Fitch Ratings’s report, please click on the following link [registration may be required]: The Extreme Credit Cycle – Making Sense of a 1% U.S. High Yield Default Rate.

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Posted in Corporate Bonds, Corporate Credit, Corporate Defaults, Economy, Personal Finance

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Deflation – No Comparison to Great Depression

Posted on July 26, 2010 by | Leave a comment

Lately, both the producer price index and the consumer price index have been showing possible signs of deflationary forces taking hold in terms of lower prices for goods and services, with consumer prices dipping slightly for three consecutive months.  However, so far, even with the significant declines in home prices, we have not experienced anywhere near what happened to prices during the Great Depression.

All of us, save a very few, have lived only in times where inflation was the greatest concern to investors and deflation was a legend—existing more in mythology than fact.  Employees generally expect their wages to increase to, at least, keep ahead of inflation, and since prices for goods and services generally increase, companies have the dollars to afford the wage hikes.  Using monetary policy to keep inflation in check while allowing the economy room and liquidity to grow has been the Federal Reserve Board’s main job for decades.

Every once in a while though, economic imbalances (i.e., massive debts in some countries countered by massive surpluses in others) can build to a point where consumers run short of liquidity in their personal finances to continue to make purchases at a rate that would continue to grow gross domestic product.  Consumers then get choosy about what they buy and at what price the buy the product.  As demand slows, prices stagnate and, in some cases, begin to drop as inventories pile up.  Not all consumers jump at the initial price, but rather, they wait to see if the price falls further.  As prices drop, and companies earn less on their products and services, wages and jobs drop, too, which makes consumers more nervous about their economic future, forcing them to cut back on spending even more.  The deflationary cycle thus continues until economic forces come back into balance.

This is why investors should be more concerned about deflation than inflation, for deflation is not kind to companies, and thus equities.  That said, Casey B. Mulligan, Professor of Economics at the University of Chicago, recently pointed out in the New York Times blog, Economix,  that the deflation in the U.S. in 2008, and what may be building now, is nothing compared to deflation during the Great Depression.

In the spring and summer of 1929, consumer prices, especially commodities, were on the rise.  Thus, banks were heavily lending to farmers as the price for their crops was increasing (this was before farmers could use futures contracts to lock-in the price of their crops ahead of season).  However, “In the fall of 1929, the inflation stopped and prices headed down (incidentally, that’s when the Great Depression began), falling almost every month for nearly four years. By the summer of 1931, when the Depression was about two years old, this deflation had brought prices down almost 13 percent from their 1929 peak. It was difficult for homeowners and farmers to make mortgage payments as their income fell sharply.”

By contrast, the deflationary spell that begin in October 2008 as the credit crisis hit its peak lasted only a couple of months before inflation returned.  One of the biggest differences between these two periods, though, is the government’s response.  At the outset of the Great Depression, the Federal Reserve, misreading the problem, raised the target federal funds rate, thus choking off liquidity and exacerbating the deflation in prices.  In 2008 and since, the Fed has responded by providing huge volumes of liquidity to markets, including lowering the federal funds rate target to a range between 0 and 0.25 percent and using its own balance sheet to buy mortgage-backed securities and support credit markets.  So, with the amount of money bring injected into the economy, seeing deflation reverse to inflation so quickly may not be surprising.

However, with the recent trend that may be forming toward lower prices, and continued hemorrhaging in the housing market, it is unclear whether the Fed has staved off a Great Depression-like deflation.  Has the Fed been successful or merely kicked the can down the road?  What happens if deflation sets in with the Fed already having provided as much liquidity as it can?  What would it do then?  These are tough questions with no clear answers, but investors must find a way to be prepared, just in case.

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Posted in Central Banks, Deflation, Economy, Federal Reserve Board, Monetary Policy

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Fed Hemmed In By Mortgage Securities, ZIRP

Posted on July 23, 2010 by | Leave a comment

In Federal Reserve Chairman Ben Bernanke’s recent semi-annual report to Congress on monetary policy, Bernanke attempted to show that the Fed is not “out of bullets” when it comes to ways to stimulate the economy.  However, having implemented a zero interest rate policy (ZIRP) with the target federal funds rate in a range between 0 and 0.25 percent, a policy the Fed may be locked into for another year or more, and also having purchased a multitude of mortgage-backed securities to backstop the mortgage market, the Fed may find itself painted into a corner with little ways to help a U.S. economy that is not growing nearly fast enough to create jobs.

Last year, the Federal Reserve intervened in the housing market, providing most of the funds for new mortgages. The central bank is stuck with dealing with those mortgage securities as demand builds for more economic stimulus. Holding onto the securities could be costly for the Fed and hinder its ability to battle inflation, according to The New York Times. Selling the securities could hurt the economy by draining money from it.

A wide range of economists say the Fed’s program — so big that purchases outstripped the issuance of new securities in some months — helped to preserve the availability of mortgage loans and helped to hold interest rates near record lows. Rates that exceeded 6 percent in late 2008 remain below 5 percent today.  Certainly, the Fed’s asset buying programs have worked, but it cannot hold those securities forever, and selling them anytime soon  would be difficult  to do without draining the money from the economy, thereby hurting what little growth there is.

The issues surrounding the Fed’s interest rate policy are equally perplexing.  Two economists recently noted in research on low-interest-rate traps, “Strict adherence to inflation targeting can produce interest rates that are too low, pushing the economy into a ‘low-interest-rate trap.’ Low interest rates induce too much risk taking and thus increase the probability of crises. Crises, in turn, require low interest rates to prop up the financial system. In a weakened financial system raising rates becomes extremely difficult, so central banks remain stuck in a low-interest-rate equilibrium, which in turn induces excessive risk taking.”

The U.S. is currently trapped in its ZIRP policy because raising rates would harm the fragile recovery.  Bernanke reiterated the policy of the Federal Open Market Committee (FOMC)  in his recent Congressional testimony: “Over the course of the crisis, the FOMC aggressively reduced its target for the federal funds rate to a range of 0 to 1/4 percent, which has been maintained since the end of 2008. And, as indicated in the statement released after the June meeting, the FOMC continues to anticipate that economic conditions–including low rates of resource utilization, subdued inflation trends, and stable inflation expectations–are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

This may explain in large part the yo-yo action in equity markets of late, as those who are concerned about lackluster growth that is almost entirely due to government, and not private, spending battle with investors will to take risks when cash is earning zero.  The action will come to a head when either the economy shows clear signs of stumbling in the wake of reduced government stimulus and the Fed struggles with what to do to help (this could come in the form of another significant drop in home prices) or the Fed acts to relieve itself of its mortgage assets and raises rates.  Investors, stay tuned.

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Posted in Banking, Central Banks, Economy, Federal Reserve Board, Monetary Policy, Residential Mortgage-Backed Securities, Securities

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Several Years of Slow Growth in U.S.: Bernanke

Posted on July 22, 2010 by | Leave a comment

In his semi-annual report on monetary policy to Congress on July 21, 2010, Federal Reserve Board Chairman Ben Bernanke remarked on the Fed’s outlook for the U.S. economy that we can expect continued moderate growth, a gradual decline in the unemployment rate, and subdued inflation over the next several years.  Specifically, Bernanke forecast U.S. gross domestic product growth of 3 to 3.5 percent in 2010, and roughly 3.5 to 4.5 percent in 2011 and 2012.  If the U.S. were coming out of a mild recession, that level of growth would not be too bad.  However, coming out of a severe recession, if not a depression, and with unemployment near 10 percent, the forecast GDP growth will not be enough to return the economy to pre-recession levels.

Bernanke acknowledged the challenges. “After two years of job losses, private payrolls expanded at an average of about 100,000 per month during the first half of this year, a pace insufficient to reduce the unemployment rate materially. In all likelihood, a significant amount of time will be required to restore the nearly 8-1/2 million jobs that were lost over 2008 and 2009. Moreover, nearly half of the unemployed have been out of work for longer than six months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers’ employment and earnings prospects.”

Bernanke also spent some time discussing the various plans to withdraw the economic stimulus the Fed has provided in terms of liquidity in markets through the expansion of its balance sheet.  However, he concluded, the economy is not in good enough shape to begin withdrawing those stimulative programs. “Of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain. We will continue to carefully assess ongoing financial and economic developments, and we remain prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability.”

Testimony of Fed Chairman Ben S. Bernanke on Semi-Annual Report on Monetary Policy to Congress

Federal Reserve Board Semi-Annual Monetary Policy Report to Congress

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