ECONOMIC GROWTH V/S INFLATION FOR INDIA

By Jay Thakkar and Harshal Sharma

Introduction

There is great debate over the belief whether inflation promotes economic growth or not. The relationship between inflation and growth is a controversial one not only in theory but also in empirical findings. A group of economists supporting Keynes are of the opinion that inflation is a factor that contributes to economic growth. Keynesian theory states that inflation leads to redistribution of income and wealth. Keynes favors mild inflation on the grounds that it tends to increase business optimism due to rising prices, resulting in high profit expectation that stimulates further investments, output, employment and income. However, another group of economists are of the view that inflation does not contribute to economic development but on the contrary, works as an inhibitor. For instance Milton Friedman completely disagrees with the policy of development through inflation. We have tried to investigate the interactive effects between inflation and economic growth for India and the need for regulating inflation in its current developing phase.

The Relationship between Economic Growth and Inflation

The relationship between inflation and economic output is very delicate. Investors highly value GDP growth, as cash flows that are the key driver of valuation/performance of company’s stocks won’t increase if economic output of a country is falling or is in a steady state. On the other hand, if there is too much growth in GDP it leads to an increase in inflation, which undermines stock market gains as the money and future profits become less valuable than they are today. Today, most economists agree that a growth rate of 2.5 – 3.5% is safely attainable without any negative effects.

Over time, the growth in GDP would lead to inflation, and the rate will keep on rising as inflation engenders inflation. Once this progression starts, it doesn’t take much time for it to become a self-reinforcing feedback loop. The Rational Expectations Theory suggests that in the times of increasing inflation, households tend to spend more money as they are aware of the fact that the money will be less valuable in the future. Because of more expenditure by the people, there is an increase in GDP in the short run that leads to further increase in the prices of the goods and services. Also, a very peculiar feature of inflation is that the effects of inflation are nonlinear, i.e. 10% inflation is not just twice as harmful as 5% but much more than that. Most advanced economies have learned these lessons through experience. In 1980s when there was a prolonged period of high inflation in the US, the economy was restored only by going through a painful period of high unemployment and lost production, as prospective capacity remained idle.

So what is the ideal inflation level? While some economists insist that advanced economies should aim to have 0 percent inflation i.e. stable prices, the general consensus is that a little inflation is actually a good thing.

Relationship between GDP and CPI Growth Rate for India

The graph below plots the quarter on quarter GDP growth rate and CPI growth rate. It can be observed that economic growth rate is inversely related to CPI growth rate.

figure-1Untitled.png

It can be observed that there is a significant relationship between GD growth rate and inflation growth rate represented by a negative correlation coefficient. The value of adjusted R square is low due to other factors like exchange rate, technological development, natural resource availability, social and political conditions that influence the economic growth.

Major Reasons why Economic Growth and Inflation Control can’t go together

When inflation is high, interest rates are hiked. The reason being, a high interest rate will discourage additional borrowings. This shall reduce the amount of money people have in their hands to spend. Traditional economic theory suggests that as demand falls, prices also fall. Thus, RBI aims to control inflation by increasing interest rates. When economic activities falter, a cut in interest rates is required. This is because companies need to borrow in order to invest in new projects. A fall in interest rates reduces cost, thereby increasing profitability. This encourages borrowing, which in turn, helps fuel the economy.

A high interest rate is detrimental to growth. Companies discontinue expansion or growth plans due to high interest rates. They are forced to cut costs to maintain profits. This passes across the economy including the labor market. A low interest rate can cause a rise in inflation. This is a result of more money in the system. This leads to an overall price rise as demand increases. A high interest rate controls inflation but retards growth. In contrast, a low interest rate is beneficial for overall economic growth. Therefore, both economic growth and inflation cannot be targeted together.

RBI’s Stance

The goal of RBI’s monetary policy is primarily price stability, while keeping in mind the objective of growth.

The Dr. Urjit Patel Committee Report posited a few key recommendations; in 2014 a “glide path” for disinflation was announced. The aim was to maintain the CPI inflation at 8% by January 2015 and below 6% by January 2016. The Agreement on Monetary Policy Framework between the Reserve Bank of India and Government dated February 20, 2015 wants to maintain the consumer price index-combined (CPI-C) below 6% by January 2016 and 4% (+/-) 2% for the financial year 2016-17 and all subsequent years. Whilst formulating the monetary policy we focus on price stability and growth. However, the focus on each of these objectives varies across time depending on the evolving macroeconomic conditions. Various changes in the economic environment will dictate alteration of the objectives to facilitate the maintenance of price stability to ultimately achieve growth.

The Reserve Bank of India controls the amount of money in the system as well as the dominant interest rates. It reviews its policy regularly through the credit policy. This is dependent on multiple macro-economic factors like inflation, industrial production data and job growth. This often leads to a debate over growth and inflation control. India has never followed inflation targeting as a tool to control inflation. But, according to Narasimham and Rajan committee the central bank clearly lacks direction and needs one tool to focus on develop their monetary policy. They say that in a country like India where the central bank is independent of the government and the inflation rate is considerably low, a monetary policy targeted around keeping the inflation rate low and stable will accelerate output growth. Inflation targeting helps in reducing inflation volatility and inflationary impacts of shocks. It also leads to increased anchoring of inflation expectation.

There was a lot of backlash regarding this move as people felt that the central bank has various factors to monitor such as price stability, growth and financial stability and that India does not have the framework for the successful implementation of IT such as developed financial markets, confidence of global markets, and independence of RBI. Inflation targeting would also restrict the RBI’s ability to respond to financial crises or unforeseen events. It could also lead to potential instability in the event of large supply side shocks.

Conclusion

A macroeconomic policy ideally should aim at high economic growth accompanied with low levels of inflation. However, in reality, accomplishing both a low inflation rate and a rising economic growth is never possible. However, low inflation rate does not indicate slow economic growth. In situations of excess money, consumers begin the process of bidding which results in escalation of the cost of goods. In the case of Indian economy, a number of studies failed to establish any conclusive relationship between inflation and economic development. Low level of inflation is advantageous for development, but once inflation goes below a certain level it retards economic development. Therefore, it is mandatory to perform inflation control at an acceptable level to promote optimum economic growth.

Appendix

Year Quarter Total Gross CPI GDP growth rate CPI growth
2011-12   Q1 19717.87 106.489
Q2 19109.98 110.658 -3.08% 3.91%
Q3 20737.12 112.553 8.51% 1.71%
Q4 21501.59 113.311 3.69% 0.67%
2012-13   Q1 20779.26 117.29 -3.36% 3.51%
Q2 20468.18 121.458 -1.50% 3.55%
Q3 21743.09 123.922 6.23% 2.03%
Q4 22474.99 126.098 3.37% 1.76%
2013-14   Q1 22164.9 128.856 -1.38% 2.19%
Q2 21990.4 134.773 -0.79% 4.59%
Q3 23122.19 138.172 5.15% 2.52%
Q4 23566.2 136.493 1.92% -1.22%
2014-15   Q1 23805.34 138.971 1.01% 1.82%
Q2 23781.78 143.769 -0.10% 3.45%
Q3 24661.67 143.769 3.70% 0.00%
Q4 25026.12 143.689 1.48% -0.06%
2015-16   Q1 25514.35 146.048 1.95% 1.64%
Q2 25520.95 149.446 0.03% 2.33%
Q3 26353.58 151.445 3.26% 1.34%
Q4 26883.03 151.245 2.01% -0.13%

Table 3

Source: RBI website

Bibliography

  1. Inflation and economic growth. (2010, October 13). Retrieved July 28, 2016, from http://www.economywatch.com/inflation/economy/economic-growth.html
  2. Barnes, R. The importance of inflation and GDP. Retrieved July 28, 2016 from http://www.investopedia.com/articles/06/gdpinflation.asp
  3. Retrieved July 30, 2016, from http://www.economicshelp.org› Economics help blog › economics
  4. Gokal, V & Hanif S. (2004, December) Relationship between Inflation and Economic Growth. Retrieved July 29, 2016 from http://rbf.gov.fj/docs/2004_04_wp.pdf
  5. Mohaddes, K & Raissi, M. (2014, December) Does Inflation Slow Long-Run Growth in India? Retrieved July 28 ,2016, from https://www.imf.org/external/pubs/ft/wp/2014/wp14222.pdf
  6. Salian, P. & Gopakumar. Inflation and Economic Growth in India –An Empirical Analysis. Retrieved August 1, 2016, from http://www.igidr.ac.in/conf/money/mfc-13/Inflation%20and%20Economic%20Growth%20in%20India_Prasanna%20and%20Gopakumar_IGDIR.pdf
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  8. Help, & Terms, S. P. (2014, August 25). Inflation versus growth: Why RBI can only pick one. Retrieved August 2, 2016, from https://in.finance.yahoo.com/news/inflation-versus-growth–why-rbi-can-only-pick-one-102654757.html
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harshal-sharmaAbout the author:

The author is currently a student of batch 2015-17. His area of interest is Banking, Economics and Corporate Finance. You can contact him at harshalsharma2015@gmail.com

img-20161015-wa0007About the author:

The author is currently a student of batch 2015-17. His area of interest is Economic Analysis, Corporate Finance and Investment Banking. You can contact him at  jaymmakhecha@yahoo.com

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QUANTITATIVE EASING: A WAY OF STIMULATING ECONOMIC ACTIVITY?

By- Purvee Khandelwal

One of the main tools to control growth is raising or lowering interest rates. Lower interest rates encourage people or companies to spend money, rather than save. But when interest rates are at almost zero, central banks need to adopt different unconventional policies – such as pumping money directly into the financial system i.e. quantitative easing, or QE.

How does it work?

The Central bank purchases financial assets – mostly government bonds – from pension funds, insurance companies, and banks, among other institutions, with electronic cash. It paid for these bonds by creating new central bank reserves – the type of money that bank use to pay each other and the amount of commercial bank money used for lending purposes.

Who has tried QE?

Between 2008 and 2016, the US Federal Reserve in total bought bonds worth more than $3.7 trillion. The UK created £375bn ($550bn) of new money in its QE program between 2009 and 2012. Then in August 2016, the Bank of England said it would buy £60bn of UK government bonds and £10bn of corporate bonds, amid uncertainty over the Brexit process and worries about productivity and economic growth.  The Eurozone began its program of QE in January 2015 and has so far pumped in $600bn of extra money.

What are the expected gains?

 The new money swells the size of bank reserves in the economy by the quantity of assets purchased—hence “quantitative” easing. Like lowering interest rates, QE is supposed to stimulate the economy by encouraging banks to make more loans. The idea is that banks take the new money and buy assets , such as give loans, to replace the ones they have sold to the central bank. That raises stock prices and lowers interest rates, which in turn boosts investment, spending, and consumption.

What are the risks?

The biggest concern is that pumping more money into the economy could ultimately lead to an inflation problem. Also, the newly created money usually goes directly into emerging markets (through financial markets) and commodity-based economies. Thus, local businesses may not get adequate loans. BRICS countries argue that such actions amount to protectionism and competitive devaluation as QE causes inflation to rise in their countries and penalizes their industries. Thus, a far more effective way to boost the economy would be for the Central bank to create money, grant it directly to the government, and allow the government to spend it directly into the real economy. However, this could also lead to reckless spending by government. Hence, the debate on what tool to use to boost growth continues.

IMPACT OF US FEDERAL RATE HIKE ON EMERGING ECONOMIES

By Vinit Intoliya

Edited by Shulin VK Satoskar

Introduction

The end of Quantitative Easing (QE) policy and tightening of monetary policy (ending the zero rate policy) by US Federal Reserves has added fuel to the grow- ing fear in emerging economies’ debt and equity capital markets. During the period 2009 to 2013, the emerging economies received large foreign investments, Fed alleviated the losses caused by the subprime crisis. Now the tables have turned and die is being rolled by US Fed as its economy has almost recovered. The fall of Chinese stock market has also forced Chairperson of Federal Reserves to hike interest rates. The brunt of this huge pile-up of trillions of dollar as debt will decrease the local currency value of emerging countries, which will further make servicing of these debts costlier and create volatility.

Dollar Carry Trade

Let us rewind the story a few years back when the financial crisis of 2007 struck with the burst of Housing bubble. The resulting crisis led to sharp cutbacks in consumer spending. The dual combination of financial market chaos and decrease in consumption led to collapse in business environment leading to contagion effect around the globe. US Federal Reserve resorted to various steps to boost the economy which includes the unconventional path called Quantitative Easing (QE). Three rounds of QE has raised the Federal Reserve’s balance sheet from around less than $1 trillion in 2007 to more than $4 trillion now. Along with QE, Federal Reserve used the most common approach to revive the economy by using zero interest rate policy (ZIRP). Both the steps were taken to increase investment and pump up more money into the economy.

From 2010 onwards, the yields had fallen drastically and investors were forced to search for higher yield financial instruments around the globe. The reason be- ing ZIRP and changes in bond buying behavior of Federal Reserve. At this time, many countries around the world have been impacted but emerging markets re- main financially intact i.e. overall financial position is good and are offering higher yields. This has created a situation of dollar carry trade i.e. a company in emerging economies issues US dollar denominated bonds which provides higher yield compared to US bonds. Hence, investors borrow money at zero interest rate and invest in emerging markets thus gaining higher yields. In turn, corporates of emerg- ing markets invest the proceeds from the sale of bonds into higher yielding instruments.

This whole scenario of global carry trade has been initiated due to large interest rate difference between emerging economies and U.S. This also led to the spiral of money supply growth which fueled economies and thus increased the demand for emerging markets bonds.

Why did Fed decide to increase interest rate?

From last year onwards, taper tantrum decision of Fed gives investors a hint that the honeymoon period of borrowing money at zero interest rate will be over soon. There were various reasons due to which Fed thinks that current US economy is in sweet spot to raise the interest rates.

– Controlling Mortgage and Unemployment rate

One of the intentions of US central bank behind the availability of easy money in the US economy was to bring the mortgage rate under control and once again individuals start investing fixed assets. From year 2008 to 2015, Fed was able to bring down the mortgage rate by around 200 percentage point. Currently, the US mortgage rate is hovering around 3.90%.

During the global crisis the unemployment rate jumped from 5% in December 2007 to 9% in June 2009 (as per National Bureau of Economic Research). The recession killed around 7.9 million jobs spreading bad sentiments across the na- tion. But now according to US labor department, the current unemployment rate has again reached 5% and private sectors has made highest hiring record. The Fed strongly believes that this improvement in employment rate will bring desired inflation and wages.

I2A1D1

I2A1D2

As consumer spending and wages have improved, the main agenda of Fed is to maintain the inflation which is persisting in the economy. In FY’15, in the first 6 months the country was experiencing negative inflation and in April’15, it touched -0.20% and currently in Aug’15 inflation is +0.20%. The Fed wants to maintain this inflation rate in the economy and to increase the cost of borrowings which will keep the economy on an even keel.

I2A1T1

Fed Effect on Emerging Economies

With interest rate tweaks in any economy, there is higher probability of huge capital inflow and outflow from the economy. Whenever central bank increases the interest rate, it directly affects the currency of those countries. And when US hiked the interest rate, dollar will be strong and there will be a huge impact as it is rightly said by IMF Chief Christine Lagarde that it will create “spillover effect” and spread volatility in the financial markets. Impact on emerging economies can be seen in terms of reversal of capital flows and high US dollar denominated debt. These both factors are inter- dependent on each other.

I2A1D3.png

As there is huge money outflow from the economy, it basically means For- eign Institutional Investors (FIIs) are taking out their money which they have invested in stock markets of the countries. It will create negative sentiments and there will be net sellers’ environment. Hence there will be dollar outflow from the economy and countries own currency will become weaker in terms of dollar. This directly impacts the trade of the country. From the below figure, it is clear that in last six months that the export and import of emerging economies are suffering a lot.

I2A1D4

The huge impact has been largely faced by India and China. Six months before, export and current export has changed drastically. If at this time Fed in- creases the interest rate, there is higher chance of creating environment of “Twin Deficit” i.e. current account deficit and fiscal deficit of each country will increase and worsen the economy. The dwindling capital inflows will make countries in EM worse to pay their debts, spend on infrastructure and hence less corporate expansion.

The latest report by IMF says that the borrowings of emerging economy countries have been doubled in the last 5 years and reached to US$ 4.5 trillion. The foreign companies’ US dollar debt were increased from $6 trillion to $9 trillion. Since 2008, according to funds tracker EPFR, there is total outflow of US $9.3 bn during the 2nd week of June from emerging markets. In the past 7 years, emerging markets have seen biggest weekly outflows. Hence, own currency de- valuation and concurrent back flow of capital will make debt repayment difficult for emerging countries. Therefore, the strong dollar will create a ripple effect.

Is it really a matter of concern?

The continuous capital outflow has posed danger to the whole economy or this brunt will be faced by just equity traded funds market. It depends on each country on how to manage their monetary and fiscal policies and how it remains financially intact from external shock. In Feb’15, the Fed issued a list of countries calling “Fragile Five” which can be highly vulnerable to increase in interest rates. The list depends on each country’s external financial exposure. Brazil, Mexico and Turkey are in most threatening situations

I2A1D5

It is believed that all countries that lie in EM category will not suffer badly. It rather depends on how fundamentally strong are the policies of each country. It can be seen that this whole outflow of money is not due to the fear that Fed is increasing interest rate but it is due to China stock market bubble crash and bad policies system which governs the economy.

I2A1T2

For example, Brazil was once praised for its robust growth but now it is facing huge criticism due to massive public debt, corruption and continuous interest rate tapering leading to high inflation. This led S&P to downgrade the bond to junk category. Due to this, investors are thinking about parking funds elsewhere.

This behavior of ‘beggar thy neighbor’ policy creates upheaval at the macro level. At the same time, India is looking fundamentally very strong from a long term perspective. Currently, the reaction in Indian stock market is due to herd mentality. Basically it means that when there is panic at a global level, it will lead to high selloff. Equity market is more of a sentiment driven market. At this juncture, the main indicator which will quantify the strong position of economy will be debt to GDP ratio and other Foreign Exchange Reserves. Currently, all the countries in EM have decent amount of foreign reserves which makes them shock proof and able to survive for short run. But in the long run, central bank and government of each country need to work together and make policies financially viable rather than managing according to the impact of hiked rate in US.

Bottom Line

Current exodus of capital is more due to fundamental changes in an economy and not because of fear of increasing rates. The end to bond buying program of Fed reserves from 2013 has send clear indication that Fed will increase the rates in future but once it will be done the after effects will be transitory. The emerging economies are facing structural breakdown and this slowness is directly or indirectly related to China. The latest stock market crash of China and US Fed thinks of hiking interest rate are coinciding. On this hypothesis, we cannot create causation effect as this turbulence is due to the fear of interest rate hike. If in future also the US Fed is increasing interest rate, the most vulnerable countries would be the one that depends a lot on external financings and also who have low foreign reserves.

References:

How Do U.S. Interest Rate Hikes Affect Emerging Markets – Article published by Owen Davis

Goldman Sachs sees limited impact of Fed rate hike on emerging markets – article published by Sue Chang

Stop Blaming China – Article published by Brian Kelly Fed rate Hike – Article published by Amit Mudgill

Fed rate Hike – Article published by Amit Mudgill

THE ROLE OF INTEREST RATE IN INFLATING ASSET PRICE BUBBLE

By Astha Mehta & Nayan Saraf

Edited by Sachit Modi

Introduction

Since the inception of the financial market, the interest rate has had a significant impact on various financial assets. The direct impact can be seen on the bond prices, which have an inverse relation with the interest rates. It also affects the deposit and lending pattern in the sense that with the fall in interest rates, the deposits decreases while the lending increases and vice-versa.

However, the impact is not just limited to the change in the saving and investment behavior of the individuals and bonds, but also extends to the valuation of various financial assets like stock prices, currency, real estate etc. This can be explained using the Gordon’s Model. The modelasset1 explains the valuation of an enterprise by discounted cash flow method. For example, any firm giving regular dividends, say $100, will have different values for different interest rates. When the interest rate (r) is low, say 1%, the value of the firm is, 100/r, i.e. $10,000. But as the interest rate goes on increasing to 25%, the value of the firm exponentially declines to $400. This is one of the reasons why in the low-interest rate regimes, the price of assets are high and vice versa. This is shown in Figure 1.

Similarly, the currency value is also influenced by the interest rates. Although, there are various factors affecting exchange rate, like economic stability, domestic good’s demand etc., but interest rate has a significant effect on the appreciation and depreciation of the currency. A decrease in interest rate is unattractive for foreign investors resulting in shifting of foreign investments to other countries with relatively higher returns. This weakens the domestic currency. As currency loses value, investors look for other investment sources like gold and real estate. Thus, the effect percolates down to these assets also.

These changes in the value of the assets cause investors to modify their portfolio holdings. There have been instances throughout history where the change in the interest rate has driven investors to alter their portfolio in such a way that asset bubbles were created. Now let’s look at some of the major asset bubbles which stirred the global economy.

U.S. Housing Bubble

The U.S. housing bubble is a perfect example where the lower interest rate was one of the key reasons to inflate the housing prices. The lower interest rate had given the opportunity to the investor to buy the house when the money was virtually freeasset2. The common explanation for the lower interest rate goes back to the hypothesis of “Global Saving Glut” by Ben Bernanke, Ex Fed Chairman. According to Ben, prior to the housing bubble, there was an excessive saving generated in the emerging market which was channelized to the U.S. market, and subsequently lowered the long-term real interest rates. He argued that a shortage of safe assets could also have contributed to the problem.

This fact could have been evident from the yield of 10Y U.S. Government bond, where the lower real interest rate has reduced the bond  yield from a high of 8% in 1995 to as low as 4% before the housing bubble (Figure 2).

Now this lower bond yield had caused the investors to shift to other risky investments. And real estate seemed to be an ideal choice for the investors then. During the post dot-com bubble era, the effective Federal Fund Rate was reduced dramatically from 6.5% to just 1%. This long-term lower interest rate had resulted in the dramatic increase in the asset prices (Housing). By 2006, this interest rate was normalized from 1% to 5.25% and people started regretting the exorbitant prices they paid for the assets which were overvalued. It brought about lower demand and increased monthly payments for adjustable rate mortgages. Soon after that, a series of defaults started, resulting in the bursting of the bubble. Figure 3 explains the same.

asset3

However, it is not completely true that the lower interest rate was the only reason which created this bubble. As Raghuram Rajan argued in his book, “Fault Lines”, that if there are other factors that encourage investment in a single asset, then the impact is amplified to an extent that asset bubbles are created. 2 This phenomenon was clearly evident in the housing bubble of 2007 when not only interest rate but also government policies like home buyer’s credit, easy lending practices, Fed’s focus on job creation rather than output, inefficiency of credit agencies etc. were equally culpable for it.

Japan’s Real estate bubble

A similar scenario can be seen in Japan’s real estate bubble. The Japan asset bubble started when US dollar depreciated against the yen due to the signing of the Plaza Accord by the US with Germany, England, France and Japan. The dollar depreciation boosted US exports, but at the same time made investors shift investments from the US to Japan due to foreign exchange fluctuations.

The rising value of yen hindered business opportunities for Japanese exporters. To protect its export market, Bank of Japan resorted to monetary easing by lowering the interest rates from 5 percent in 1985 to 2.5 percent in the early 1987. The free lending by Japanese banks increased the real estate and stock purchases which inflated the value of land and stocks. During this period, Nikkei tripled to 39,000 and real estate prices reached a record high. It was even rumoured that during this phase the Tokyo Imperial Palace was worth more than the entire state of California. The price rise continued for four years, until 1989, when BOJ finally increased interest rates on account of inflationary pressures, and caused the asset bubble to burst.

The Nikkei plunged from 39,000 to 20,000 in 1990 and retail loans became NPAs which resulted in the Japanese government to take twenty years to recover back to the pre bubble economy which is now commonly referred as the lost two decades.

asset4
asset5
The Japan debt crisis was also a result of lower interest rates. Lower interest rates allow governments to fund its economic spending through cheap debt. A part of government’s revenue is used to pay interest on the debt taken. When interest rates are kept low for a long period, the government’s borrowing increases and so does the interest payments. Later on, if there is an increase in the interest rate, the interest payment shoots up consuming a large part of or sometimes whole of the government’s revenue. This creates a vicious debt trap.

Shale oil production bubble

Shale oil production is another case where the low-interest rate had fuelled the gas drilling bubble. Since the crisis of 2007, Fed had kept the interest rates constant, nearly zero, which resulted in loose money being poured into the capital intensive oil drilling process for years. When these investments became successful, there was an excess supply of oil in the world economy. Since, in just a period of one year, the price of oil plummeted from $120 a barrel to just $30 a barrel, the shale oil production (drilling industry) busted.

There are more than 50 shale oil production companies in the U.S. and more than half of them have already filed for bankruptcy due to the plunging oil prices. None of these oil companies are able to reach the break-even point. And the ones who haven’t filed for bankruptcy are running in huge losses.

Now, the Fed has again increased the interest rate by 0.25 basisasset6 points and it would have negative consequences for these oil companies. Firstly, it would lead to an additional debt cost in their balance sheets. Figure 6 clearly indicates there is an increase in debt due to cheap lending and also, the increase in debt to gross cash flow, due to lower generation of cash flow from the operations. Second, the higher interest rate will increase the cost of capital, which would mean that these stressed drill companies would lose access to finance. Third, the higher interest rate will result in the appreciation of the dollar, leading to downward pressure on oil prices, due to crude oil being priced in dollars.

Conclusion

Central Banks undertake monetary easing often by lowering interest rates, in order to stimulate the economy, but more often than not, end up in creating an asset bubble. The various historic events highlight the role that interest rates have played in the financial market and its effect on the asset prices.

Even though, these events indicate that various factors contributed to the loss of wealth due to bubble formation, investors sometimes ignore the risk and fall into the trap of increasing asset prices. It is also noteworthy that the dot-com bubble burst after the Fed had increased the interest rate by 1.91% in 1999-2000. More interestingly, the current US housing index shows that the US house prices have reached to new heights while the interest rates are nearly zero. So, are we heading for another bubble? Well, it is difficult to predict as of now, but it would be interesting to see what happens to the housing prices when Fed would further increase the interest rates.

References:


astha_tjef1About authors:

The author is a Banking and Financial Service student of batch 2015-17 at TAPMI. Her area of interest  includes economics, banking, data analysis and digitalisation. She is also a senior analyst at Samnidhy. You can contact her at astha.bkfs17@tapmi.edu.in

Nayan_tjef
The author is a Banking and Financial Service student of batch 2015-17 at TAPMI. His area of interest is mainly economics, banking, and risk management. He previously submitted his research paper on REGRESSIVE EXCHANGE RATE POLICY OF CHINA. He is on the editorial board of TJEF and also the member of Literary and Media Committee of TAPMI. You can contact him at nayan.bkfs17@tapmi.edu.in.