Powell'sspeechandimportanceofInflation

The content of the speech by Jerome Powell during the Jackson Hole conference is out and, as was widely expected, there is a change in thinking about how they will go about tackling inflation. The key change would be that the Fed would now target “average inflation” rather than being guided by the number of 2% for consumer price inflation. What this means is that the Fed can now allow inflation to remain above 2% for some periods, offsetting the periods where it undershot the target. Anyways the Fed mandate was not just on the price stability front, it was always a dual mandate that gives equal importance to ensuring maximum employment as well.

What this means for wider markets is that at least the equity markets can be sure about the persistence of low interest rate regimes for some time to come. The Fed shied away from giving any mathematical underpinning to the “average inflation” calculation keeping, some space for their discretion. As we had written yesterday, such an announcement would result in dollar weakening, equity rising and yields softening. We were largely on the mark expect on the yields where the yield curve has steepened with the longer run yields going up.

Now let’s come back to the cardinal question on why inflation is so important. Raghuram Rajan in his book I do what I do tackles this question when he describes why an inflation targeting regime was adopted in India. He writes that in any economy inflation levels give out multiple types of information. Most important is where the interest rates should be. As savers need to be given a positive real rate, keeping rates low when the inflation is high results in disincentivising the saver and a rise in investment into risky assets which in turn leads to speculations and bubbles. The second argument about inflation is that it provide the price signals in the economy. In the case of rampant price increase the key information about the allocation of capital gets hazy. You may be having good profits just because generally the prices are rising and not because your product has some special feature. Last but not the least is “inflation expectations”, Rajan writes that inflation if not controlled at the onset can become entrenched.

In an interview yesterday the RBI Governor also emphasised the same point that RBI works with a legal mandate of keeping headline inflation within the range of 4%+-2% and he sees no point in discussing it further. Though he said that RBI has enough in its arsenal at his disposal for tackling growth as well and they remain vigilant about the bond market rates. The 10 year bond 5.79 2030 is trading at 6.17. The same bond was purchased at 10 bps better than the market rate by RBI yesterday in the OT auction. On the rupee, the absence of any dollar buying has resulted it in trending towards 73.50 levels. The forwards also came down yesterday as no paying was seen.

One other important news just breaking is that Japanese PM Shinzo Abe is due to resign on account of bad health. Abe, the pioneer of Abenomics, has been the Japanese Premier for last 8 years.