RBI has finally increased the repo rate after inflation has been stubbornly high for more than three quarters. I was expecting this to have happened sooner, and yet they were faster than the US central bank. Inflation in the US has been out of control for a very long time now and yet the Fed has not taken any action. Their reasoning for the longest time has been that the inflation is transitory and will eventually come down without any rate action. Why is it transitory? The explanation was that the inflation was due to decrease in supply and not due to increase in demand and when the supply catches up with the demand the inflation should disappear. So far at least that was not the case and Fed has been printing money and keeping the interest rate low. What a mess.

If what I said so far did not make any sense, let me try and help you understand. Although I am not sure if I will do a good job, because my knowledge is quite limited too :). So lets first understand inflation. Suppose there are 5 chocolates and there are 10 kids with money. They all want to buy a chocolate. Generally the shopkeeper sells each chocolate for Rs. 10. But because so many kids are asking for it, he increases the price to Rs. 12. Three kids leave because they cannot afford. Seeing how 7 kids are chasing 5 chocolates, the shopkeeper increases the price further to Rs. 15. Then only 5 kids are able to afford or willing to buy at that price. The inflation (increase in price) was because of the difference in supply and demand. If there are exactly 5 kids and 5 chocolates or 10 kids and chocolates, they would have all got one for Rs. 10.

That was a very simplified way of explaining inflation. Of course there are lot more nuances. Now, lets say in general the manufacturer of the chocolates produces 10 chocolates every day and there are 10 kids in the area to buy them. The price stays at Rs. 10 assuming that the ingredients to make the chocolates has not increased. Imagine a situation now where there is a slowdown of supply of the ingredients due to lock-down or general restrictions to the movement of vehicles due to COVID. The manufacturer is unable to produce 10 chocolates and makes only 5. And this is the situation that caused inflation that we talked earlier. There are still 10 kids in the area, but only 5 chocolates were manufactured driving up the cost of the goods.

After some days when most people are vaccinated and the situation is more in control, lets say all the restrictions were removed and there are no supply problems. All the ingredients are now coming back like earlier and the manufacturer is producing as many chocolates as before, then the price will have to come down to Rs. 10. Why? Because if the shopkeeper sticks to Rs. 15 per chocolate like he did during COVID times, then only 5 kids will buy 5 chocolates. But the manufacturer gave him 10 chocolates to sell. The rest will go waste. So to make sure he can sell all the chocolates he will reduce the price that will get him 10 kids. Lets say that number is Rs. 10. Now there is no more inflation. Pre-COVID the price of 1 chocolate was Rs. 10 and it is the same now hence inflation is zero.

That was what the Fed was hoping would happen. Their argument was that there was a lot of supply shock because of all the travel restrictions due to COVID. Once all that normalizes to pre-COVID levels the supply will increase and inflation will come down. The only problem now is that no one knows for sure if that is the case.

Going with the same example, where the supply is back to normal and the number of chocolates produced is 10. There are 10 children. However, the shopkeeper discovers that he is able to sell all the chocolates at a price of Rs. 15. Then there is still inflation now isn’t it? But how did it happen? Well it is possible that the children are getting more pocket money. Where as earlier most kids were getting only Rs. 10 as pocket money, are now getting Rs. 15 for some reason. Now all the kids can afford to buy, so each buys at the new price of Rs. 15 keeping inflation high.

Now the question arises – how did the pocket money of the kids increase? Well, it is possible seeing how the inflation is going up, the companies where their parents are working are giving more salaries. Or may be the parents demanded more salary because of increasing inflation. Alternatively, the Fed prints more money and hands over free money to the parents. Which is really happening. Whatever may be the reason, there is more money in the parent’s pockets. So the parents pass on the benefits to kids. How do we fix the situation then? It can be fixed in 2 ways.

One is to stop printing the money and handing free cash. It is easy to understand right? If you print less money, there will be less to give people and the pockets will automatically become lighter. While it sounds simple, it is not really. Fed can’t print money out of thin air. They have to create assets on one side of the balance sheet to print money on the liabilities side. It is not something I will explain here because then I will have to talk about accounting and such.

The other way is to make sure that the parents don’t have too much money in their pockets is by controlling repo rate. This is how Fed and RBI are trying to reduce inflation. I will explain how this works in my next post because this post is already quite long. I have been writing about inflation quite a bit these days. May be it is the flavor of the month until the investors find some other juicy topic and move on. Till then, you will have to bear with me.