Given the analysis below... What reaction is expected of the central bank? Can there be a threshold rate for the central bank?

IMF Working Paper

Middle East and Central Asia Department

Estimating The Inflation–Growth Nexus—A Smooth Transition Model

Prepared by Raphael Espinoza, Hyginus Leon and Ananthakrishnan Prasad

Authorized for distribution by Abdelhak Senhadji

March 2010

Abstract

This Working Paper should not be reported as representing the views of the IMF.

The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Motivated by the global inflation episode of 2007–08 and concern that high levels of inflation

could undermine growth, this paper uses a panel of 165 countries and data for 1960–2007 to

revisit the nexus between inflation and growth. We use a smooth transition model to

investigate the speed at which inflation beyond a threshold becomes harmful to growth, an

important consideration in the policy response to rising inflation as the world economy

recovers. We estimate that for all country groups (except for advanced countries) inflation

above a threshold of about 10 percent quickly becomes harmful to growth, suggesting the need

for a prompt policy response to inflation at or above the relevant threshold. For the advanced

economies, the threshold is much lower. For oil exporting countries, the estimates are less

robust, possibly reflecting heterogeneity among oil producers, but the effect of higher inflation

for oil producers is found to be stronger.

Drought in South East Asia and South Asia??? Lets keep track of this

WILL IT HAVE A FALL OUT ON INDIA AS WELL??? FAO/GIEWS Global Watch 25 March 2010 Drought in Southeast Asia affects parts of Bangladesh, Myanmar, Thailand,Lao PDR, Cambodia and Viet Nam

Since early November 2009 rainfall has been consistently below long term average in Southeast Asia, particularly causing drought in parts of Bangladesh, Myanmar, Thailand, Lao PDR, Cambodia and Viet Nam (see Figures 1 and 2). Figure 1: Anomaly (mm) from estimated rainfall (RFE) – 7 Year climatology Figure 2: Percent soil moisture Currently a secondary cropping season for rice is underway in most countries in the region, except in Bangladesh and Viet Nam where the current season is the most important one. It is also a season for winter crops such as wheat in some countries (see Table 1 for the calendar of current main crops). Because this is generally a low rainfall period in most countries, compared to the wet season that will start later in the summer from May onwards, the crops gown are typically irrigated. Low rainfall has however reduced river flows and other water supplies necessary for irrigation in many parts. River side farming practices and fishing activities, in particular, have suffered this year due to low levels of water flows affecting livelihood of dependent communities. Table 1: Crop calendar - Main cropping activities during this current season in the countries in the region Mekong River water levels at present, for example, according to the Mekong River Commission CEO, have been lowest in 20 years. Mekong River flows through six countries, namely, China, Myanmar, Lao PDR, Thailand, Cambodia and Viet Nam, covers some 4350 km and affects livelihood of more than 60 million people living by the river side. Droughts in summer and floods during wet season along the Mekong River are a long term environmental concern possibly exacerbated by a pronounced El Nino event this year and the increased number of dams upstream. Contribution of the current secondary paddy season in the annual production varies a great deal in different countries accounting for 15 percent in Lao PDR, 18 to 20 percent in Myanmar, 20 to 25 percent in Cambodia and 25 to 30 percent in Thailand. In Thailand due to much reduced precipitation since the beginning of February and so far in March, the Department of Disaster Prevention and Mitigation has declared 19 provinces in the North and Northeast and 13 in the Central and East regions as drought affected. In addition to adverse weather, damage by brown plant hopper is also reported. Based on FAO estimates, the current second season paddy harvest may hover around 7 million tonnes, down by about 1.4 million tonnes from 2008/09 and from 1.8 million tonnes from 2007/08. Low water levels in the Viet Nam’s Mekong River Delta, the country’s rice bowl, have resulted in inward flow of salt water increasing the salinity in the river water endangering rice paddy and other winter-spring crops on about 620 000 hectares. The full extent of damage to crop yields due to the drought is not yet clear but several localized crop failures are reported. The drought situation and its impact on the winter-spring crops are still evolving and needs to be watched and assessed carefully.

Manage Risks at the Origin – The Commodities Way
V. Shunmugam*
Dalal Street Investment Journal

Pg 16-17; March 15-28, 2010

Being so closely related to the basic existence of mankind, no doubt, commodities will remain the fundamental recommendation of any portfolio manager and that is what makes them so important

Man is born due to commodities, lives with commodities. Not less importantly, his end of the era on the earth also needs commodities to ceremoniously complete the same apart from other things. In short commodities are so essential to human kind’s existence on the planet for which they compete, complement, and compromise to live together in a society to produce, earn, share and use it. It is the way mankind earned these commodities and used them, that had led to the creation of an economy and the opportunities that had come along with it. To share these among themselves according to the innate value these could command for the provider and its outer use value to its receiver, money came into being which also over a period of time transformed from sheep and goats to gold/silver coin and to the current bearer note that we use today. Noted economist Keynes rightly said that money remains the only bridge connecting the values from the present to the future and with the past as well so that transactions among the stakeholders can take place smoothly easing out the happening of economic activities as well.

Unfortunately, as the innate value and the outer value of commodities differ as it takes several transformations and quite a bit of time to reach the ultimate user, it tends to give excess of money in the hands of all those who are involved in this process under normal conditions. Mankind saved this excess keeping in mind his productive and unproductive period of life besides keeping in mind the uncertainties of life. To save this excess, the economy created opportunities and paid something in return for those who have provided access to this excess in its need of creation of newer opportunities which had longer payback period such as investments in industry, infrastructure and the services sector. To trade these opportunities, mankind also created markets to function under certain own rules and regulations for the smooth conduct of its activities. In this logical sequence, no wonder, why the markets emerged first for commodities to be later replicated for the financial instruments such as stocks, bonds, interest rates and currencies in the ring, if we trace the global history for origin of financial markets. Not only because that it is the savings of the very same mankind that goes into these markets for various asset classes (stocks, bonds, currencies, etc) but also because these are connected in one way or another to deliver the primary commodities as industrial commodities or services to the ultimate users added with mankind’s own efforts (labour) in the process.

While the value addition opportunities tended to flourish in economies as they developed, increasing population and its quest for commodities other than just for its basic existence, led to a situation where commodities were getting scarcer by time and alternatives for them were hardly emerging through. Also, it led to a situation of fear among the stakeholders leading to the building up of irrationality in the markets, naturally, when emotion starts ruling the participants’ mindsets, if one were to cut him off from the short-term fluctuations especially the one which is the result of recent financial crisis there has been consistently secular trend of increase in commodity prices. Besides that, the interconnectedness of the other markets and the irrationality in them had led to a strong cross-influence on the commodity markets as was witnessed during the current financial crisis. In a nutshell, it means that one who has an exposure in one market, will be in one or another way getting affected by what is happening in the other markets. The basic cause remains that producers of goods or owners of asset classes fail to manage their risks themselves in a better way. Even if they were to, perfect risk management by any of the stakeolders is something not feasible in the real world situation.

It makes a strong case for Markowitz’s portfolio theory which suggests that an efficient portfolio should essentially be diversified, not only to yield better returns but also to guard against risks in related asset classes. Being so closely related to the basic existence of mankind, no doubt, commodities will remain the fundamental recommendation of any portfolio manager. If one takes into account the following commodity intensive industries and their raw material prices, as is evident in the table that their stock prices and their raw material/finished produce prices have a strong correlation among themselves. This is fundamentally due to the fact that risks in their raw material costs or finished product prices are not appropriately managed by them. It provides a strong case for those investing in the mentioned stocks in the table to have appropriate position in the raw materials or the finished products produced by those companies which are traded on commodity exchanges so that one can manage volatility in the stock prices directly on the commodity price movements and further earn the pure business profits, the stock of the company can generate.

Easy and cost effective way of managing this risk arising out of price movements in commodities is being enabled by way of electronic national online commodity exchanges such as MCX trading on global asset classes since 2003. While a part of the corporate sector with relevant commodity being traded on the exchange are participating in the platform, another part is allowing these risks to partly eat into their profits or manage these in the same old traditional way of managing it costlier in the physical markets. Hence, the stock market participants have traditionally tracked the international commodity prices and took notice of company’s risk management policy and accordingly decided the stock prices while trading in commodity related stocks. No wonder, why the stocks of the companies taken up for a simple correlation analysis showed a strong and statistically significant correlation with their input or output prices as traded in the commodity markets. However, with companies in themselves participating in commodity price risk management on futures exchanges we had seen some of the companies’ stock prices in the recent times show a very low correlation with the related commodities as traded on exchanges.

Another reason for commodity investing is to protect one’s wealth against inflation, the main cause of which arises out of increases in the commodity prices and hence its contagious effect on the manufactured and the services. The fact that the future is not predictable, makes savings compulsory for most human beings. However, comparative tendency of human beings (inter-personal or inter-temporal wealth) and the natural phenomenon of inflation build expectations of returns among the savers leading to the look-out for the best investment opportunities that exists in the markets. Thus emerged the markets for various such investment opportunities and the pioneer among them globally remains the commodity derivative markets followed by other asset classes. Be it for inflation management or for protecting the risks in portfolio, the best way is the manage these at the origin i.e. commodities.

*Author is Chief Economist, MCX India Limited, Mumbai. Views are personal.