The genie leaves the bottle

The genie leaves the bottle
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First Published: Tue, Jun 12 2007. 12 10 AM IST
Updated: Tue, Jun 12 2007. 12 10 AM IST
At first glance, there is no connection between the decision of Tata Consulting Services (TCS) to recruit 5,000 Mexicans and the spectacular gyration that the US 10-year government bond yield witnessed last week. But both share a lot in common—they indicate inflationary pressures in India and the US.
The reason treasury yields are rising is that bond investors are getting nervous that inflation in the US is about to get out of hand, at worst, or remain sticky at present levels, at best. Both possibilities mean a Fed that either holds rates steady or raises them. Bubbly assets do not like higher rates.
The decision of TCS to set up an office in Mexico and recruit 5,000 programmers there is a sign that India’s supply of skilled labour is not adequate to meet demand. As a result, wages are rising sharply, eroding the competitiveness of software firms. They are trying to meet the challenge by going to lower-cost locations.
Rising wage pressure is evidence that aggregate demand is running ahead of aggregate supply. The Reserve Bank of India (RBI) may still have some work to do.
Economic textbooks would tell you that, in mature and developed economies, the bulk of the responsibility for managing business cycles falls on monetary policy. A developed economy is usually considered to have fully deployed its resources. Hence, any slack or overheating is a consequence of a demand shortfall or excess demand. In developing countries that are still catching up and which have substantial inefficiencies and/or underutilization of resources, improving the availability and usability of resources is as important as reducing demand pressures to cope with inflation concerns.
When the government of the day cannot alleviate supply constraints, the monetary authority has to cool aggregate demand and, at the same time, face criticism that it was choking growth. On top of this, in recent times, the liberalization of financial flows complicates monetary policy management. Domestic tightening measures are ineffective and such a capital inflow surge, in the presence of supply constraints in the economy, leads to asset price inflation and, in an inefficient economy such as India’s, consumer price inflation, too. An excellent overview of the monetary policy challenges for India is to be found in a recent speech delivered by Y.V. Reddy in Chile on 7 June. It is available on the website of RBI.
A consolation for the developing world is that this is beginning to affect advanced economies, too. In a recent working paper, the Bank for International Settlements (BIS) found that global factors explained a very substantial portion of inflation trends in the developed world in recent years.
The working paper suggests that excess capacity in most sectors in the world might have been largely used up after five uninterrupted years of strong economic growth. It sounds plausible and is consistent with the recent inability of the Bank of England to reduce retail price inflation in the country and the persistently high inflation rate in the US, well above the implicit target of 2%. Nearly a year of subdued economic growth in the US has failed to lower inflation.
The president of the Federal Reserve Bank of Dallas spoke recently on how the tendency of major central banks to focus on consumer prices (while excluding energy and food prices) might be outdated. The movement in the prices of these energy and food no longer reflects transient factors but permanent global trends. Charlie Bean, chief economist of the Bank of England, made the same point two years ago. If the Federal Reserve had focused on headline inflation, it might have raised rates more and earlier. Headline inflation was at 4% in 2006. Now, many central banks are scrambling to raise rates.
Interest rate futures discount a rate of 6% in England before the year is out and the market is beginning to accept that the Federal Reserve might be forced to do so too before the year is out. That explains why the 10-year US Treasury yield broke out of its long-term declining trend and climbed to as high as 5.24% dramatically in two days. On Friday, the yield on treasuries declined.
The decline in yields once again brought out the animal spirits of investors. They sold low-yielding currencies such as the Japanese yen and bought more of the high-yielding ones such as the New Zealand dollar. The New Zealand dollar—Japanese yen cross exchange rate is up more than 100% in the last seven years. This is unsustainable.
Investors have to acknowledge soon that the inflation genie is out of the bottle and this one does not grant favours. Interest rates may have to climb more than anticipated previously. Investors must heed warning signs.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd. These are his personal views and do not represent those of his employer. Your comments are welcome at
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First Published: Tue, Jun 12 2007. 12 10 AM IST
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