What Is Inflation, Interest Rate &Recession and Its Impact

In 2020 the world’s system went haywire due to the Covid-19 Pandemic which in turn put the government into action to do something about the sudden shutdown of the economic cycle. They started to flush the system with fresh money so that the economic cycle can start with economic participants making new investments, creating jobs, providing to those who were out of work, and giving a jump start to the economy. This heated economy was bound to push inflation to another level.

Everyone is talking about the looming fear of recession in 2022 due to the high inflation rate. What happens when inflation gets out of control? What is the measure which needs to be taken for inflation by governments and central banks across the world? Before that let us understand these financial terms.

Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in prices, which is often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.

A recession is a macroeconomic term that refers to a significant decline in general economic activity in a designated region. It had been typically recognized as two consecutive quarters of economic decline, as reflected by GDP in conjunction with monthly indicators such as a rise in unemployment.

Central banks play a vital role in managing economic activity in a country. They do this by setting monetary policy. One of the tools in monetary policy is by setting a Bank Rate. A bank rate is a rate at which banks can borrow funds from central banks.

The federal funds rate refers to the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

This rate dictates at what rate participants can borrow money from the bank and controls money flow in an economy. When money flow increases in an economy, the economic cycle of demand-consumption-investments increases which expands the economy of a nation. When the economy is expanding too much too quickly it gives rise to inflation and by decreasing the cash flow in an economy they cool down the economy for which central banks increase the bank rate.

Let us look at the History of the Federal reserves Bank Rate with the rise in inflation.

(Dark Shaded period is when the US was in a recession period)

As it can be seen from the graph above, whenever The Federal Reserve increases the rate, the nation’s economic activity coolds down which in turn puts the economy into a recession period. But why does the federal reserve increase the rate in the first place? it was due to out-of-control inflation.

The US government unpegged the US dollar from the gold standard, which led to a period of high inflation in the 1970s, which was followed by Fed rate hike in the 1970s.

1970–1980: The Fed’s actions to raise interest rates are said not just to have exacerbated the 1973–75 recession, but to possibly even have caused it.

1981–1990: The Fed fights the “Great Inflation” by increasing bank rates causing a recession. That was one of the highest swings in rate in history.

1991–91: Early recession in the 1990s which was with the Internet boom in full swing, Greenspan raised rates to over 6% in an attempt to cool things down causing a small recession period.

2001–10: The dot-com bubble burst, the 9/11 terrorist attacks, and the financial crisis of 2008. The early 2000s led to the dot-com and tech company crash followed by the events of 9/11. Amid that backdrop, the Fed lowered rates 13 times to a low of 1% from over 6% when the decade began.

2010–15: In response, the Fed slashed interest rates to near-zero for the first time in history. The Fed left rates at near-zero until 2015 when the Fed raised rates by only 25 basis points 2015 and 2016. Then, in 2017–18, 7 consecutive rate hikes brought rates up to 2.5%.

Let us look at India’s scenario and how RBI reacts to inflations:

Just like the Federal Bank rate, RBI has a Repo rate. India was a controlled economy till the liberalization scheme of 1991 and the RBI started to manage monetary policy since.

As it can be seen from the graph above whenever CPI ( index for inflation) goes above the median they increase the repo rate to fight inflation. This shows inflation and interest rate have a very close correlation. This is in line with the central bank’s objective of keeping inflation in check by adjusting the interest rate. And this way, the RBI can regulate the flow of credit, capital investment, and consumption. We see from the above graph how RBI reacted to the heated economy in (2003–2008) and (2010–2019). When RBI sees inflation rising they increase the repo rate and gradually start decreasing when inflation is under control. During this period of increased interest rate, India saw an increase in lay-offs, no new investment, etc which can be seen and felt in 2022. If you compare the federal reserves rate hike is followed by RBI’s increase in repo rate because the US is the world’s financial center and it has direct as well as an indirect effect on other parts of the world and India as well.

(RBI Repo rate from 2018-current)

Post-2019, during the pandemic RBI sharply decreased the repo rate to support the economy as we discussed above. In recent times, when we look closely, the Federal reserve has been reacting slowly whereas RBI has been cautious with their policy and staying ahead and aggressive in setting its monetary policy.

How do Increase in Interest rates impact the economy?

● Cost of borrowing for business rises which reduces the business’s ability to invest in new assets.

● Cost of borrowing for consumers rises which reduce consumers spending power and decrease the consumer debt growth rate.

● Investors have better saving rate interest resulting inflow of money into those instruments and pulling money out of riskier investments

● The capital market reacts differently depending on the business in which a company operates

India’s Structural Advantage

According to the Harward Business review, any nation’s competitive advantage can be determined by these determinants:

1. Factor Conditions. India’s position in factors of production, such as skilled labor or infrastructure, is necessary to compete in a given industry that has been growing at a good rate. India’s Investment in these factors is about to reap the rewards and provide a stable floor for India to tackle the recessionary period.

2. Demand Conditions. The nature of home-market demand for the industry’s product or service is strong in India and can be seen in recent data released by Revenue (GST, Incometax) and other bodies(Ministry Of Communication).

3. Related and Supporting Industries. The presence India’s of supplier industries and other related industries that are internationally competitive due to increasing FDI and knowledge transit from partnering nations.

4. Firm Strategy, Structure, and Rivalry. The conditions in the nation governing how companies are created, organized, and managed, as well as the nature of the domestic rivalry. India has taken major policy reforms such as the implementation of Goods and service tax, Digitisation of the financial system which brought new consumers into the market, Technology development, slashing of corporate tax, and other benefits in taxation to participants.

RBI’s monetary measure is as per the direction in which the wind is blowing and proves to be an effective way to ship India’s growth which has solid structural integrity and will help navigate the recession storm.