Advantage India

What does faster economic growth of nations as a whole means to India and China? It first gets reflected in the commodity prices. Commodities and Stock indices have higher correlations during bull runs. Will India and China suffer the same impact? No! China with its pegged exchanged rate, suffers as the oil and other commodity prices zooms in terms of dollars (QE2 has a good chance of fueling dollar inflation w.r to international commodities). Whereas, the rupee which has a flexible exchange range, appreciates with the QE policy of fed and suffers very less in terms of commodity prices.

What does this means to U.S? Rising prices of commodities driven combined with the devaluation doesn't augur well for the US economy. Sooner or later, this might lead to inflation. The resulting spike in interest rate (there is a limit for the interest rate to be held down by Fed) to protect investment from inflation combined with the high employment might lead to another episode of stagflation. Fed which was already handicapped with exhausting most of its monetary policy tools, may have a tough time going forward!

The sinking ship

How long can one keep a boat with a leak afloat by pumping water? 

So long as the rate of pumping water out is more than that seeping in...

What in case, if the hole gets bigger and bigger?

.....

Fed's Open market operation with respect to its latest policy (QE2) is similar to the one mentioned above. Let us see how it is. 

It is essential that the government spends more (fiscal policies) to stimulate the economy in recession. In parallel, it also requires monetary policies to keep the interest rate low to boost consumption/ investment. But how long can these actions go hand in hand? 

In fact, these two actions are opposite in nature. As the government spends more by borrowing more, it naturally leads to increase in interest rates, which is in contrary to the objectives of the central bank,namely, to keep the interest rate low. To achieve its objective, the central bank has to buy back the bonds, which requires printing more money.

Is it possible to keep the interest just by printing the money? 

To an extent yes. Just like any other price discovery, by manipulating the demand vs supply, i.e., by buying more of government bonds (funded by printing more money), the interest rates can be artificially kept low. To the extent of printing money, the U.S dollar gets devalued against the other currencies (Dollar has appreciated so far by 7% against basket of currencies this year). By interest rate parity, a currency has to pay the rent (interest rate of U.S bond in this case), to the extent of its expected devaluation. So the interest on the U.S bonds has to give in ultimately.

At the same time, printing money has its own consequences, namely, inflation. At present, printing money doesn't lead to inflation because of 1) decrease in the velocity of money 2) Dollar being the reserve currency (which is questioned every now and then).

But in the long run, when the correction happens, the price has to reflect the fundamentals. Any moderate reverse in the direction of the economy and the subsequent increase in the velocity of money will result in hyperinflation. When such expectations starts kicking in, the status of reserve currency which supports the interest rates (to an extent) will give away, resulting in the investors asking for more rent for their investments. No amount of Fed's intervention can save the interest rates in that case.

To worsen the scenario, the U.S government has liability of over a couple of trillions in terms of social benefits without any matching assets which has to be funded again by more borrowing. The baby boomers who will be enjoying these benefits will start retiring in a couple of years. Let us see how long will the Fed be able to pump the water from this sinking ship.