How to Make Sense of the Indian Economy: Relationship between Interest Rate, Inflation, Employment and Currency

A study of how interest rates, inflation, employment, and currencies are linked with each other can be a powerful tool to assess the macro forces shaping our Economic environment.Though each of these headers serve as sufficient material to write stand-alone books, there is some utility in looking at them rather simplistically.

 

Before we go ahead into each relationship, let’s first see what these terms exactly mean:

 

1. Definitions

 

Interest rates

 

Interest rates in layman's terms represent the cost of borrowing money levied on the borrower. Likewise from a lender's perspective it denotes his/her rate of return on the same transaction. Duration plays a key role in any transaction i.e. not only looking at how much is borrowed, but for how long? This divides interest rates overall into short-term and long-term rates.

 

At a very high level, short-term interest rates are set and driven by the country’s Central Bank. This control is implemented through various monetary policy tools the Central Bank has at its disposal. To avoid digressing, we won’t get into what these tools are at this stage.

 

Nevertheless, Central Bankers’ main concern when they move short-term interest rates up or down is that they need to strike a balance between ensuring that borrowing stays "cheap" and price rises (i.e. inflation, we’ll come to that later in more detail) remain sustainable. So, in a way the Central Bank can incentivize borrowing in the economy by reducing short-term interest rates or suppress the same by increasing rates.

 

Long-term interest rates, on the other hand, are driven by the issuance and trading of government bonds i.e. borrowing instruments through which the government raises money. Long-term rates have a weaker direct correlation with inflation, employment, and currency (all again short-term metrics).

 

That’s all you need on interest rates at this stage. Will elaborate more on this subject separately through future articles.

How to Make Sense of the Indian Economy: Relationship between Interest Rate, Inflation, Employment and Currency
Source: By Soham Banerjee [CC BY 2.0  (https://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons

 

Inflation

 

Inflation refers to the increase in price of goods and services. Now there may be many reasons for an increase in prices. Higher demand than supply may be one. So can be an artificially constrained supply or easy access to borrowed funds. Inflation is usually looked at differently for households (retail inflation) vs. businesses (wholesale inflation) . This is because people buy goods & services in limited quantities, whereas businesses buy them in bulk (thereby benefiting from deals and discounts usually offered to big buyers).

 

The former is gauged by a metric called Consumer Price Index (CPI), which is tracked month on month. Similarly, business inflation is tracked via the Wholesale Price Index (WPI). The basket of items within each metric are in broad terms reflective of the typical products people and businesses buy e.g. cereals, vegetables, milk, meat & fish, transportation etc. for CPI and manufactured products, including commodities, wholesale food articles etc. for WPI.

 

Due to India’s import dependence on crude oil and weak supply chain structures, CPI is looked at both including and excluding Fuel and Food items (which comprises more than 50% weighting for the tracked basket of items). The former is addressed as CPI and the latter as Core CPI.

How to Make Sense of the Indian Economy: Relationship between Interest Rate, Inflation, Employment and Currency
Source: By Vladimir Kirakosyan [CC BY-SA 3.0  (https://creativecommons.org/licenses/by-sa/3.0)], from Wikimedia Commons

Employment

 

The country’s employment data comprise important metrics, of which the “unemployment rate” is the principal benchmark. It gives a sense of how many people are not employed and by extension, not receiving wages, and how many are. It henceforth becomes a proxy for the country’s consumption or spending capacity.

 

Harmonized all-encompassing employment data is typically difficult to find in India due to our huge informal sector. In more mature economies such as the United States, employment data is tracked and analyzed with much granularity. US, for instance, tracks its monthly Nonfarm Payroll number i.e. the number of new jobs in the non-farming sector created Nationally. This data gives analysts a sense of the current state of the Economy and predict future levels of Economic activity. The Indian labour market is unfortunately not tracked in such detail, with metrics calculated on an annual basis instead of monthly. Moreover, the data for all realistic purposes excludes the informal sector, which reportedly hires almost 86% of the work force. Read this interesting report by McKinsey to understand the structural challenges with employment data in India.
How to Make Sense of the Indian Economy: Relationship between Interest Rate, Inflation, Employment and Currency

Currency

 

The Indian Rupee (or for that matter any currency) is constantly pegged against other currencies in Global Foreign Exchange markets. Institutions such as big banks, pension funds, insurance companies, commodity traders, other corporations etc. are constantly buying or selling one currency in exchange for the other. These transactions set the exchange rate of currencies with respect to each other. The more Dollars you sell to buy Rupees, the stronger will be the Rupee value with respect to the Dollar. The extent of buying or selling a currency, aside from individual transactional considerations, also depends on a few external factors.

 

Trade i.e. exports and imports act as key drivers. More imports mean more payments in foreign currencies are required, leading to more selling of one’s domestic currency. Exports have an inverse effect.

 

The Central Banks of countries can also conduct open market transactions to enhance or deplete their foreign currency reserves (by buying or selling US government bonds for example) and thereby “stabilizing” their domestic currency. This means in case of India, if the Indian Rupee value is too volatile with respect to the Dollar, the Reserve Bank of India (India’s Central Bank, popularly referred to as RBI) could consider selling US government bonds (denominated in Dollars) it holds on its balance sheet and in turn buy more Rupees to strengthen its position.

How to Make Sense of the Indian Economy: Relationship between Interest Rate, Inflation, Employment and Currency 

2. Relationships

 

Now that I’ve gone in a fair bit over the terminologies, let us assess how they relate with respect to each other.

 

I place them in 3 buckets with individual relationships shown as sub-bullets:

 

Interest Rates vs. Inflation

  • Higher interest rates → Lower inflation
  • Lower interest rates → Higher inflation

 

Interest Rates vs. Currency

  • Higher interest rates → Stronger currency
  • Lower interest rates → Weaker currency

 

Employment vs. Inflation

  • High employment → Higher inflation
  • Low employment → Lower inflation

 

Let us look at them in order:

 

Interest Rates vs. Inflation

 

When interest rates are increased, the cost of borrowing money from banks would go up. This in general leads to a tightening of money supply in the Economy. It means people and businesses borrow less money. Less borrowed funds imply a reduction of spending and investment. For instance, people tend to wait for interest rates to drop before taking a car loan or a home loan. Business also tend to reduce purchase of capital goods as borrowing has become more expensive.

 

All this is expected to reduce overall demand, which as any Economist will tell you leads to a reduction in prices i.e. Lower inflation.

 

However, when interest rates fall, the above-mentioned cycle gets reversed. Borrowing becomes cheaper and hence people and businesses borrow and spend more. Demand thereby picks up leading to an increase in prices i.e. Higher inflation. 

 

Interest Rates vs. Currency

 

The country’s interest rates set the rate of return an investor can expect when they deploy their capital in that country. Imagine you are an investor who has the option to deposit the same amount of money (say $X) in either a bank account in India or in the United States. In India the bank will pay you Y% on your deposit, whereas in US the bank will pay you Z% on the same amount. Your decision to lock your money in India vs. US will largely depend on the rate differential you make in one country vs. the other…as well as the risk that which bank may default and fail to pay you anything. Y% will most probably be higher than Z%, but locking money in an Indian bank is a riskier proposition than locking it in a US bank. US has a more sophisticated banking system and legal protection in case the American bank fails. Same can’t be said about India.

 

Hence typically when interest rates in India increases, investment in India increases. More investment means investors would buy more Rupees, hence Rupee appreciates.

 

When rates go down, the differential vs. other countries reduces and hence there is a capital outflow. Rupees are sold in exchange for Euros, Dollars, or Pounds and hence our currency weakens.

 

Employment vs. Inflation

 

When a bigger piece of the working population joins the work force, there is an increase in spending as more households receive wages. This should theoretically translate into more spending, leading to higher demand and hence an increase in prices. The reverse order should follow the same logic. This inverse relationship between unemployment and inflation is an economic concept called the ‘Phillips Curve’ – it has exceptions countered by Milton Friedman (1976 Economics Nobel Prize winner). However, that discussion is for another day.

 

When employment increases, another implication is that employers are competing for the best talent. This results in higher wages and hence increased spending. Therefore, reducing unemployment has a dual impact on spending – more people start receiving a salary and over time the salaries themselves go up (exceptions apply to this assertion as mentioned earlier).

 

No wonder employment data is a good mirror to assess the Economy’s current growth and prospects. It is an indicator of the health of companies i.e. whether they’re keen to invest, spread operations, and as a result hire more workers. It is also an indicator of where consumption and spending are headed.

 

Next week I will do a deep-dive to better understand interest rates and how they work. Stay tuned.

 

This will be a recurring column published every Friday under the title: “How to Make Sense of the Indian Economy

 

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