By Ruma Dubey

It is a very pertinent question – why do countries like Europe, America and Japan have low inflation when almost all developing countries are suffering from seemingly pandemic high inflation rates? There, countries have almost zero percent interest rates and their Governments are looking at ways and means to hike rates and push up inflation. On the other hand, we here, sweltering in the heat, are smothered under high interest rates as well as high inflation. Though, off late the rates have been somewhat under control, one has to take into account the seasonal factor.

Low prices or deflation in simple economics means falling prices; so isn’t that a good thing? After all everyone loves it when prices fall. But deflation in recessionary times is not good. Just as inflation reduces the value of money, deflation increases the value and thus people do not want to spend it, prefer to sit on the cash. People feel that prices could come down further and hence wait. Companies are also likely to sit on cash as they feel it is less profitable to produce as it gives them lower real returns. They cut down on production and new investments and spike up unemployment. Thus deflation feeds recession which is what led to the Great Depression. Inflation can be pro-growth but only when it is not unusually high where then it starts working like the way persistent deflation does.

The vast majority of developed countries are currently reporting a headline inflation rate of below 2%, with the trend in virtually all of them headed downwards.  As per Haver Analytics, which publishes economic and financial data across developed and developing economies, has stated that out of the 25 developed economies, Iceland is the only country with inflation.  The developed countries are indeed looking at ways and means of getting out of this extra low interest rates and their first step towards that was the exit from monetary easing policies. Hopefully we will see Fed Chief Janet Yellen hiking rates before end of 2015?

In the USA, one would have thought that printing so much money through QE should have ideally jacked up prices but that did not happen as the Fed did not increase the ‘stock of money’ but purchased bonds or printed treasury notes which today form a part of the QE. But then shouldn’t this have led to households buying more bonds from commercial banks, which in turn could have led to inflation? The Fed was smarter this time around and since 2008 decided to pay interest on excess reserves or reserves they are required to be held against deposit liabilities. Paying interest on reserves allowed the Fed to place a floor on the federal funds rate, since depository institutions have little incentive to lend in the overnight interbank federal funds market at rates below the interest rate on excess reserves. This was a very important move as apart from keeping a tight leash on inflation, it also ensured that as the Fed began exiting QE, it continued to have a better control on the level of excess reserves.

Things are worse off in Europe whose economy unlike that of USA, continues to flounder. Most of its economies are grappling with huge debts and with low inflation, effective real interest rates have nose dived to almost sub-zero! Furthermore, inflation projections for 2015 are being revised downwards.

Thus Central banks in developed countries are paying the price for inflation-adjusted real interest rates at rock bottom levels. Rising inequality is also leading to more hoarded or unused savings which again causes a glut. Also post the 2008 crash, households across these developed countries were quick to deleverage and wanted to repay debts quickly, leading to very little new borrowings as spending also disappeared. Consequently, these fiscal or structural changes meant to be measures to save the economy are today threatening to cripple them again. Low or stable fuel prices and very low rates of increase in wages in almost all economies are also reasons for low inflation. 

Our RBI has its own set of issues, very different from the developed world. But be thankful that we have high interest rates or else imagine earning a meager 1.5 to 2% on your deposits? Can we ever retire if we live on low interest rates?

So the grass will always look greener on the other side, but it is better to rest on your own weeds than discover than the grass on the other side were nothing but fallen leaves.