Growth & inflation – two sides of the same coin

Liquidity in the economy is a double-edged sword. Policy makers stimulate growth, as well as arrest inflation using it. The expected results are to be achieved by sustaining the abundance / crunch in liquidity.

The initiative starts with printing more currency notes; bond buybacks & Long-Term Repo Operations (LTRO) are frequently used methods to infuse the printed notes into circulation. RBI takes a call as to the quantum & type of bonds to be bought back, quid pro quo printed notes. Bonds nearing maturities maybe preferred since their market price tends to adjust in line with face value. Bond buy backs are used to alter the yield curve as well. Buying back bonds in circulation from the secondary market limits their supply, catapults price & softens yield. (Inverse relation between bond prices & yield). Coupon rate is what the government pays, yield is what the investor earns. Rising yields have been doing rounds in the media during recent times.

Bond yields are an indicator of economic health. The Financial Times defines the yield on a risk-free government bond as being roughly “equal the rate of growth in the economy, plus the rate of inflation.” Rising bond yields is a precursor to rising debt levels and widening fiscal deficit (Borrowing of the government). The rising debt levels in turn cascades into sovereign credit rating, investor confidence and inflation. Downgrade in sovereign credit ratings in turn impacts, govt securities ratings & yields. The effect is felt when commercial banks are downgraded to sub-investment/ junk grade. It is pertinent to note that PSB – public sector banks are owned by the sovereign of India. The commercial banks find it more expensive to issue “Letter of credit”, “Letter of Guarantee” etc, affecting the exporters and importers. The effect further seeps into commodity prices in the economy, for instance – Crude imports would be expensive on account of expensive letter of credit. Inching up prices are borne by the consumers, affecting the “Consumer Price Index” in the economy. When the burden is not allowed to flow through the cycle, as in price cuts in the form of subsidies etc, it further worsens the debt level of the sovereign. The essence of ‘cascading’ can be felt through this explanation. Furthermore, higher yields tend to compensate for excessive credit risk involved. Developed economies borrow at comparatively lesser rates (USA, European Nations) owing to higher investor confidence in their sovereign. Wonder why fixed deposits get their principal eroded in some economies? It’s a testimony to the level of credit risk, banks in such nations suffer. The most developed nations reward investors meagrely, owing to the implicit investor confidence. Getting back to inflation, the cycle could be hampered, either by incentivising domestic production or arresting excess liquidity in the economy. The latter is achieved through bond issuance; the former by LTRO etc. Under LTRO – government generally prioritizes sectors and lends at the base rate. RBI lends at repo to commercial banks, commercial banks in turn to the sectors. Arresting liquidity reduces, not only inflation, but stimulus & growth prospects as well. Central banks across the globe have adopted an accommodative stance unanimously, despite inflation concerns, post pandemic – solely to foster growth. The onus is on RBI to stimulate growth & curb inflation in a calibrated manner, in the days to come. Ergo, growth & inflation are two sides of the same coin.

Arunachalam Sivaraman

Published by adithyaarunachalam

I'm a millennial, from Chennai, India. Passionate about building up a career in finance, I follow and stay abreast on news feeds. I'm a novice blogger, So feel free to pass on your conjecture to me

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