GS Paper 3
Syllabus: Economy
Source: Indian Express
Context: US’ inflation rate was at 9.1% in June, the highest in 40 years, and FED action to increase the interest rate has led to few terms coming up in focus.
Bond yield curve inversion
- Bonds are essentially an instrument through which governments (and also corporations) raise money from people. Typically government bond yields are a good way to understand the risk-free interest rate in that economy.
- The yield curve is the graphical representation of yields (profit) from bonds. E.g. If one was to take the Indian government bonds of different tenures and plot them according to the yields they provide, one would get the yield curve.
- Under normal circumstances: any economy would have an upward sloping yield curve (meaning normal profit from investment in the bond).
- Inverted Bond yield curve: As one buys bonds of longer tenure — one gets higher yields. This is logical. If one is parting with money for a longer duration, the return should be higher.
- However, An inversion of the yield curve essentially suggests that investors expect future growth to be weak.
- For instance, bonds with a tenure of 2 years end up paying out higher yields (returns/ interest rate) than bonds with a 10-year tenure.
Mechanism: When investors feel buoyant about the economy they pull the money out from long-term bonds and put it in short-term riskier assets such as stock markets. In the bond market, the prices of long-term bonds fall, and their yield (effective interest rate) rises. This happens because bond prices and bond yields are inversely related.
However, when investors suspect that the economy is heading for trouble, they pull out money from short-term risky assets (such as stock markets) and put them in long-term bonds. This causes the prices of long-term bonds to rise and their yields to fall.
Over the years, inversion of the bond yield curve has become a strong predictor of recessions. In the current instance, the US Fed (their central bank) has been raising short-term interest rates, which further bumps up the short-end of the yield curve while dampening economic activity.
Soft-landing
When a central bank is successful in slowing down the economy without bringing about a recession, it is called a soft-landing — that is, no one gets hurt. But when the actions of the central bank bring about a recession, it is called hard-landing.
- Given the massive gap between the current US inflation rate — over 9%— and the Fed’s target inflation rate — 2% — most observers expect that the Fed would have to resort to such aggressive monetary tightening that the US economy will end up having a hard landing.
Reverse Currency War
As the US FED rate increases, the investor finds it more attractive and less risky. So, more and more investors are rushing to invest money in the US. This, in turn, has made the dollar become stronger than all the other currencies.
- The relative weakness of their local currency against the dollar makes their exports more competitive. This can be good for economies.
- However, today, every central bank is trying to counter the US Fed and raise interest rates themselves in order to ensure their currency doesn’t lose too much value against the dollar. This has been termed ‘reverse currency war’. E.g. India being import dependent, a weaker currency would mean a higher import bill and therefore RBI is trying to defend Indian Rupee against Dollar.
Related News:
“Zero-coupon zero principal instrument” (ZCZP) means an instrument issued by a Not for Profit Organisation which shall be registered with the Social Stock Exchange segment of a recognised StockExchange.
- These are meant for NGOs and on it, NGOs are not required to pay principal or interest after the completion of the project.
Recently, the Ministry of Finance has declared ZCZP as securities.
- Securities are fungible and tradable financial instruments used to raise capital in public and private markets. There are primarily three types of securities: equity—which provides ownership rights to holders; debt—essentially loans repaid with periodic payments; and hybrids—which combine aspects of debt and equity.
Insta Links
US FED raises rate by 75 basis point
Practice Questions
Q. Discuss the trends of recession faced by India in the past. Will the recent action by US Central Bank induce a risk of recession for other economies such as India? Analyze. (15M)
Q . With reference to the Indian economy, consider the following statements: (UPSC CSE 2022)
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- If the inflation is too high, the Reserve Bank of India (RBI) is likely to buy government securities.
- If the rupee is rapidly depreciating, RBI is likely to sell dollars in the market.
- If interest rates in the USA or European Union were to fall, that is likely to induce RBI to buy dollars.
Which of the statements given below is/are correct?
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- 1 and 2 only
- 2 and 3 only
- 1 and 3 only
- 1, 2 and 3
Answer: (b)
Justification:
Statement 1 is incorrect: To control inflation, the RBI sells the securities in the money market which sucks out excess liquidity from the market. As the number of liquid cash decreases, demand goes down. This part of monetary policy is called the open market operation.
Statement 2 is correct: If the rupee is depreciating, RBI pumps the dollar into the market, this results in an increase in foreign currency supply and a decrease in Rupee supply, thus appreciating its value.
Statement 3 is correct: If interest rates in US and EU fall, investors would like to park more money in emerging markets such as India for better returns, thus Indian market would be flooded with foreign currency. To stabilize it, RBI would likely buy excess dollars.
With reference to the Indian economy, what are the advantages of “Inflation-Indexed Bonds (IIBs)”? (UPSC 2020)
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- Government can reduce the coupon rates on its borrowing by way of IIBs.
- IIBs provide protection to investors from uncertainty regarding inflation.
- The interest received as well as capital gains on IIBs are not taxable.
Which of the statements given above are correct?
(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3
Answer: A
The coupon rate is the rate of interest paid by bond issuers on the bond’s face value. Inflation-indexed bonds (IIBs) provide insurance to investors from inflation and cost savings for the Government on account of a reduction in coupon payments by lowering the inflation rate, eliminating of uncertainty risk premium, and containing inflationary expectations.
Statement 3: Extant tax provisions will be applicable on interest payment and capital gains on IIBs. There will be no special tax treatment for these bonds.
