Who wrote this article?

Deepak Shenoy, Capitalmind's research team.

What does the "A Quick Update from Last Week" section say?

We had noted that the Markets were likely to have a slow medium term decline, because of the low volumes near new highs. The Nifty has fallen 200 points (3%) and the Bank Nifty has fallen 6%. In one Premium post, we had noted three factors that should be of concern. Bond yields were rising, the rupee was falling and our proprietary indicator was showing a downside move. Bond yields have now 9.05% (on the 10 year), a disturbing move up. The dollar has moved quickly to Rs. 63.72 from the 61.5 levels last week. Our proprietary indicator continues to show weakness (details in a future post). And the Bank Nifty is seriously down. The Bank Nifty position (straddle) has however not made any real profit (in fact is down about 8%). One of the reasons is that a faster move was expected and hasn’t yet happened. But the week is, like many nights, still young.

Macronomics: “Core” CPI, Inflation and a Major Problem in IIP Numbers

This is the archive of Macronomics Newsletter, part of Capital Mind Premium.

To all new subscribers to Capital Mind Premium, welcome! Today, we learn a little more about the details on** Inflation, Money Supply and IIP data.**

In October’s Consumer Price Inflation data, we saw inflation spike up to 10.1%.

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Most of that was Food prices, which has a 50% weight in the CPI. Food inflation itself was over 12%.

But the argument central bankers have is that they can’t control the price of food or fuel through monetary policy. This is a bad argument to make in general because like all such cases, the answer lies in the specific context. Let’s come to that later.

If we took them at face value, what would** “core” CPI** be at? Answer: Still too high.

With about 7.63% inflation we are still much higher than the “comfort” zone of the CPI. While this month seems to have brought down “Core” CPI from 8% to 7.65%, it is likely that in combination with the high food inflation, core CPI will go back up (there’s a small lag effect here).

Note: I don’t believe “core” WPI. Because Wholesale Prices are simply not updated properly, and I’ve written in detail about that. (The Wholesale Price Index cannot be Trusted)

But Food is impacted by interest rates

Coming to the argument itself, I believe food and fuel prices are controllable by interest rates. Interest rates impact both supply and demand. Look at food for a few minutes.

We have had a great monsoon this year. There cannot be production problems in agriculture. India’s population hasn’t grown out of proportion, so demand is more or less the same. And prices of food work closely with the market - rising up and down as supply and demand change. With increased supply and static demand, prices should be stagnant. However, even after the monsoon, prices remain high. Why?

Could it be that the middlemen are hoarding stuff? Could it be that supply isn’t reaching the markets? Could it be that low interest rates make it much easier for these middlemen to hoard and store and lock away food from markets, in anticipation of higher profits because of the shortage of supply? If that’s the explanation, higher interest rates will curb that speculation.

More importantly, the action will force out

Forcing the Government Hand

Higher rates will also prompt the government to act, as the higher rates will mean a higher fiscal deficit, due to higher interest payments. A high fiscal deficit can seriously derail further investment, hurt our country’s ratings and so on. The government will have to act in a fiscal way - if it has to, by dumping excess stocks in the FCI warehouses.

FCI has over 67 million tons of Wheat+Rice as of November 1, 2013. What we need as “buffer” stock is just 22 million tons. The government is scared of hurting farmers, but it is imperative that we dump this stock on to the market immediately and strictly maintain only as much buffer stocks as required. This will reduce basic prices very fast, and prices of other things will also drop. Will it take interest rates to go to 12% before the government caves in and HAS to do this?

We Are Continuing To Print Money

And the next problem? India has printed altogether too much money in the last decade. The way things work in India is that the RBI prints money, called “Reserve Money” which is basically money that is used to do the following:

Buy US Dollars in the currency markets
Buy Indian Government Bonds in OMO Auctions
Buy Gold or other assets when it has to.

Once this money enters the banking system, it “multiplies”. Imagine a bank that lends Rs. 100 to one person who puts it into his account in another bank. That bank then keeps 4% of that money as CRR, and lends the rest (partly to the government by buying bonds, partly to other people as loans). Those people again put their money into other bank accounts. And so on. The resulting money is far greater than anything RBI ever printed and is called the “broad” money supply.

Broad Money Supply - for which I’ll use “M3”, a metric that denotes the sum of all deposits in the banking system - is now over Rs. 87 lakh crores (Rs. 87 trillion) versus only Rs. 16 lakh crores (16 trillion) as reserve money. Effectively, the multiplier is 5.5 times. Every new rupee printed is multiplied by around that much.

If the total money supply available grows by too much, then it’s too much money chasing the same goods. True, we are producing more of the same goods - more foodgrains, more vegetables and more industrial turbines. But if the money supply growth is even higher, then the excess money will cause inflation in prices.

Let’s look at how reserve money has been growing recently, and you’ll find an alarming change of trend.

The problem is: RBI has been allowing the rapid increase of reserve money. It has been buying too many government bonds, it has been buying too much foreign currency (to “build” reserves). This doesn’t cause inflation today - it will hit the market within two years. Look carefully and you’ll see a very high money supply growth in the 2010-11 period, which is probably what is hitting our inflation today. We actually got that under control during a small part of 2012, and we needed prolonged money supply contraction (or very low money supply growth) to hurt inflation.

Instead, we’ve turned our backs on inflation thinking only of the currency impact and therefore the foolish rush to build reserves. All this will do is ensure there is even more inflation in future.

Rate Hikes are the Main Solution

We can talk about how to reduce inflation through government action, or penalising hoarders or anything of this sort. We can talk about how the government can help by selling their hoard. We can say that the market infrastructure needs to be improved. But inflation, so deep rooted (it has remained high for over two years now) is now more of a monetary phenomenon. In essence, we have to make money scarce, and make it expensive - both of which are things that RBI can do very easily, by hiking interest rates and taking out money from the system (by cutting reserves of do

llars and selling government bonds).

This will almost surely cause a recession today. But it’s now a battle of losing a little today for a better tomorrow, versus an even worse tomorrow. Will the RBI bite the bullet?

IIP Upmove on “Electricity” But No Such Luck Next Month

The Index of Industrial Production (IIP) data was in as well today, for September 2013. Again, we noticed a 2% increase, and most of that stemmed from an increase in the “Electricity” index, which has a 10% weightage.

Electricity production went up a lot in September but it is likely to have been because of the base effect. Getting data from the Central Electricity Authority, it turns out that the IIP (Electricity) Index is closely related to the production data from the CEA, as evidenced from the graph below.

And here you can see why September 2012 was an anomaly and why things will look a lot different in October 2013, whose data will come in December. Essentially, on December 12, if production in other places doesn’t pick up, we’re going to see a low or negative IIP figure again.

We already have data for October - thanks to CEA’s tentative production statistics, which tend to be fairly accurate. Using that and plotting growth rates, shows us this graph for where IIP (Electricity) will be:

And as you can see: IIP Electricity will be lower, and it contributed to more than half of IIP’s growth in September. And IIP Electricity has grown at a much lower level in October.

Therefore IIP (October) will be a lower number when it’s announced on December 12, unless October has seen a big jump in manufacturing or the mining indexes. Since the PMI for Octoberstill shows contraction, we can’t expect that either. A low number for IIP is almost definite; from a trading standpoint, it would make sense to set up appropriate positions to take advantage on December 12 (IIP is announced after market hours).

A Quick Update from Last Week

We had noted that the Markets were likely to have a slow medium term decline, because of the low volumes near new highs. The Nifty has fallen 200 points (3%) and the Bank Nifty has fallen 6%.
In one Premium post, we had noted three factors that should be of concern. Bond yields were rising, the rupee was falling and our proprietary indicator was showing a downside move. Bond yields have now 9.05% (on the 10 year), a disturbing move up. The dollar has moved quickly to Rs. 63.72 from the 61.5 levels last week. Our proprietary indicator continues to show weakness (details in a future post). And the Bank Nifty is seriously down.
The Bank Nifty position (straddle) has however not made any real profit (in fact is down about 8%). One of the reasons is that a faster move was expected and hasn’t yet happened. But the week is, like many nights, still young.

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Disclaimer

Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.

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