Home prices and inflation in India

Karthik Shashidhar has a piece in MINT today on how inflation is generated in India. It is a good piece that shows the expected (intended) and the unintended consequences.

(1) This paragraph could have been better worded to make it clear that he was talking about rents and not home prices because the latter does not figure in the CPI.

“Both these come together to raise the market clearing price for rental homes, which then results in a higher housing index and consequently a higher CPI. In other words, given the weightage of housing, and that it is measured using rentals only, a higher policy rate can actually result in higher CPI.”

(2) The theoretical basis for this paragraph is somewhat incomplete, if not incorrect:

The idea behind monetary policy influencing prices is that higher interest rates result in higher spending on interest-sensitive factors which reduces demand for other items, which, in turn, results in a drop in inflation. In other words, spending on interest rate-sensitive expenses can crowd out spending on other stuff, which can mitigate the price rise.

He is focusing on inelasticity of interest payments since it is a contractual obligation. That too is a factor but that is not the main (theoretical) purpose of higher rates.

Interest rate is the price of money. Everything else being equal, higher the prices, the lower the demand for money. Liquidity demand will drop and spending will be lower and money will be left in banks as savings. That is, savings rise consequently.

Further, if cost of capital raises, at the margin, some projects will not clear the hurdle rate and investment demand for funds too will decline.

(3) On a different note, Urjit Patel has written a paper last year that shows that, in a world of SLR and government claim on banking resources, lower interest rates can actually decrease credit availability and hence, not meet credit demand.

That is another unintended consequence along with what Karthik writes about higher interest rates leading to reduced housing demand and hence upward pressure on rentals.

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