Brazil Fights Inflation With Crazy Rate Hikes; Shouldn’t India Do So Too?

11 comments Written on January 20th, 2014 by
Categories: Inflation, RBI

The Brazilian Real has fallen 18% in the last year, from 2 to the USD to 2.36, and the recent recovery has reversed almost completely since October.

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On wednesday, the Brazilian Central Bank raised interest rates to a whopping 10.50%, having raised rates by 325 basis points in the last year!

The move was a “continuation of the adjustment of the benchmark interest rate that began in the April 2013 meeting”, the central bank said in a short accompanying statement, giving no further explanation.

Basically, inflation has been high in Brazil, which has seen extreme hyperinflation in the early 90s, with prices rising as much as 6000% over the previous year (at some point). This is obviously not something they want to repeat, and therefore rates have been kept high to try and get inflation below the 4.5% levels that the central bank is comfortable with. In that fight, interest rates have been hiked and the concepts seemed to have worked till November.

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But the December number came in at 5.91% (wrongly marked as Jan in the chart above). This was higher than the earlier month. In November, the Brazilian central bank had used language that implied they would “slow down” the pace of interest rate hikes. But the reversal in the direction of inflation has spooked them and the 0.5% hit came about.

Look carefully - interest rates are at 10.5%, while inflation is at 6%.

You’ll note that Indian repo rate are 7.75% while our consumer price inflation is 10%. The fight against inflation will require interest rates to be MUCH higher than inflation for a long time before Inflation is brought under control.

Case in Point: The US in the 70s.

In the 70s, the US faced huge inflationary pressures after the oil price rises. The fed ignored it because they believed that an external price shock like oil price rises cannot be countered through monetary policy, but they had left the inflation for too high for too long. It took a Volcker to come in and raise rates to a tremendously high level before inflation was tamed.

From National Affairs:

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In the mid 70s when inflation first touched 12%, it came down to 6% soon, largely through market corrections, and interest rates weren’t hiked too much. And soon, inflation rose back to 13% when Volcker had to act strongly. 10 year treasuries went all the way to 15% and the economy went into a deep recession and inflation dropped to 3%.

And then again, inflation went quickly back up to 5% while Volcker raised rates again, causing a second recession, but bringing inflation rapidly under control.

The Point, for India

We should not consider minor improvements in inflation (like CPI coming down from 11% to 10%) as a reason for RBI to cut rates or to even keep rates stable. While they intend to protect the economy from a recession, it might just need a recession in order to get inflation under control.

The fact is that interest rates might need to stay very high, for a very long time in order to curb inflation. We don’t have the Brazilian history of hyperinflation, but the fear of extreme inflation is always going to be there.

In my opinion, the RBI must raise rates to much higher levels - more than 12% - and keep them there until CPI Inflation rates fall below 5% for a sustained term. If Brazil is an indicator, this is how things will be in the next few years; it’s now been nearly four years of extreme inflation and we are quite close to an inflexion point where all the growth in the economy will be due to inflation alone.

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About the Author:
http://www.capitalmind.in
The man behind Capital Mind. Deepak is a co-founder at MarketVision, a financial knowledge company. Deepak also provides data research and consulting services, and now lives in Bangalore. Connect with him at deepakshenoy@capitalmind.in.

11 comments “Brazil Fights Inflation With Crazy Rate Hikes; Shouldn’t India Do So Too?”

Deepak,

Have you ever considered the fact that interest rates (whether high or low) are the main cause of inflation? Our money is loaned into circulation at interest which keeps compounding over a period of time usually at a rate greater than GDP because no lender lends money at an interest rate lower than GDP growth rate. It is this increasing interest cost which is then passed on to the final consumer and this is what leads to rising prices. Most of the prices that we pay for basic necessities include a significantly high interest cost. Refer to the link below.
http://realcurrencies.wordpress.com/2012/01/17/budget-of-an-interest-slave-2/

The only way to permanently eradicate inflation without sacrificing growth is to reform the monetary system. Interest needs to be replaced with either a transaction cost or a circulating fee to prevent hoarding of money. By increasing interest rates to reduce inflation by reducing demand, you are advocating for certain sections of the economy to be made bankrupt! This will lead to even more unemployment, class warfare and more socialist schemes such as free food, housing, LPG, etc which will then be paid via our taxes.

Paying and receiving interest is deeply rooted into our psyche because of our false education system which justifies charging interest by the concept of time value of money and the fact that lenders have to be compensated for the risk that they are taking. These two points can be easily buttressed by the fact that banks (who are major lenders) do not lend deposits but create new money when making a loan and then charge us interest. The banker has not actually worked for the money that he lends. He had simply created the money and then charges interest on the money that is created. Second, by abolishing interest, economic growth will actually be characterized by falling prices of goods and services due to improvements in productivity and technology. So even if money is lent without interest, one is experiencing an increase in purchasing power due to falling prices.

excellent…u have almost said everything my friend whatever i have thought about.

Let me add we are sitting ona time bomb which —will explode this decade .When u have Central bank and the money changers rigging the mkt we are in for a shock.

@Karl

increase in purchasing power==== Will lead to Demand Pull Inflation.

if money is lent without interest== Than people will not respect money resources will be misused.

Actually I feel this inflation is artificially created for sometime to suck money out of the economy through various means and fund Upcoming Election.

Mantri Ka Kaam Banta Bhaad May Jayee Janta.

@Raj Singh,

In a sound economy with interest free money, supply will always create it’s own demand. All of us are engaged in the exchange of goods and services to improve our standard of living.

As a simple example, if I am a baker the reason I supply bread is because I am having excess bread and am deficient in other goods and services. So my supply of bread is because of the fact that I have a demand for other goods and services. I can only demand 5000 rupees of other goods and services by supplying the quantity of bread that is worth 5000.One cannot demand more than his own production in the economy. This does not lead to demand pull inflation because I can only demand “stuff” by supplying other equivalent wealth. This is the reason why barter economies never face inflation. In an economy where money is lent at interest, bankers get to have a free lunch. They do not supply any tangible wealth but end up owning most of the wealth that is produced by the real economy via the compounding interest mechanism. So all demand pull inflation actually comes from the banking side because people are forced to borrow money not for productive purposes but to simply repay the interest.

I define inflation as an unjustified / unlawful increase in cost of goods and services because of the huge interest component that we are required to pay and which we do not realize.

Money is the most ingenious invention of mankind which allows for specialization but unfortunately is corrupted by this interest mechanism. Lending money interest free does not make people lose respect for money. Lenders have other ways of making profit and the debt still needs to be repaid. Lenders can charge a transaction fee similar to what brokers charge us when we make investments. They can also take a certain equity stake where their profits are based on the profits of the companies that they have invested in. It is actually the interest burden that is making people lose their self respect and is leading to mis-utilization of resources.

Builder lobby , Industry lobby and first family of builder recyclers are far to strong.

The gov / rib have taken no action as property prices have tripled / quadrupled in last 8 yrs, Singapore, Indonesia i guess have but not India.

I just saw a cnbc video of ex gov subba r justifying his inaction in a seminar with the last 4 govs.

The only thing i guess that will force the rbi/ finmin hand will be international inflation and change of stance of fed and ecb… we will need a paul volker at the fed not a janet yellen !

Hi Karl,
then India will be more like Japan. Japan is experiencing deflation from last 10 years.
Deflation will cause even more hoarding of money. Imagine, a car you get for 100 Rs today and you get it at 90 Rs 1 year later. What will you do?
Also, deflation kills export by causing currency overvalued.

@Sanjay

Japan’s deflation is simply the market correcting the excesses for the past inflation that they suffered. Their central bank never controlled excessive speculation in real estate and their stock market during the bull run in the 80s. When the bubble burst they kept bailing out their banks by printing more money. They are facing deflation now because their economy has reached debt saturation and defaults in the economy are inherently deflationary because money supply reduces when debts are written off. The deflation that we will experience will also wipe away the excess debts that have been built up during the last decade in our country.

The monetary reform that I am advocating will reduce prices not due to reduction in the money supply (deflation) but due to efficiency improvements and elimination of interest. There is a large percentage of population that at the moment cannot afford basic amenities. If the prices come down by eliminating interest, a lot of demand will be unlocked and we will once again experience productive and balanced growth.

People do not postpone their purchases permanently simply because they expect prices to fall. You gave me an example of a car reducing in price and saying that I will hoard money if I expect the price to come down. Will the reduction in price not lead to more potential buyers for the cars produced by the automobile company. Can everybody afford a car in our country at the moment? By your logic why are people not spending as much now when inflation is high and will keep going higher due to the effect of compound interest? A majority of the people’s incomes do not rise as much as inflation and that is what causes stagflation which is an appropriate description that our economy is going through.

As far as exports are concerned, please understand that we are a nation of 1 billion plus people providing the domestic manufacturer’s a huge untapped market. By increasing the purchasing power of the people who at the moment are suffering from inflation, we are improving their livelihood and self respect. The exporters may temporary suffer losses in the overseas markets but the domestic market will get more lucrative for them in the long run. Also we are a major importer of crude oil and are energy deficient. Don’t you think that oil prices will be significantly reduced if the rupee appreciates in value? Depreciation of the currency only benefits exporters whereas appreciation of the currency benefits everyone including previous exporters because the domestic market becomes more lucrative.

It is almost like the bottom 70% of this country, who should be the most affected by this inflation have either lost their voice or aren’t really that affected anymore.

The rulers, knowing this have stopped caring, and hence while inflation numbers get routine lip service from all responsible, little real action is being taken.

Point being, till when. I hope before it is too late.

Deepak, I find you are the only one who is (rightly) consistently advocating higher interest rates!

The argument is often made that raising rates will not bring down inflation, since inflation is due to supply side constraints. This argument is fallacious. The point is not the absolute level of inflation but the relative level that matters. India’s industrial slowdown is caused by negative real interest rates on savings, which has killed demand. The only way to set that straight is to raise rates and provide positive real interest rate to savers. Only then, demand will pick up. It will also bring money back into the banking system from other avenues like gold, real estate and even from under the mattresses!

This is a very interesting point and I think needs to be outlined using data. Thanks for the feedback mate!

To increase spending, you have to give threat that “go and spend, because your rupees are going to value less tomorrow”. That is what inflation is doing.

If interest rates are increased, then people will stop putting money in gold, real estate. At the same time, they will decrease spending either because EMI has gone up or deposit rates are too lucrative to ignore.

Debt spurs spending. And low interest rates suggests people to go in debt.

Thats why Ben Bernake slashed the interest rate to almost 0.