Low inflation helps central bank boost economy, positive for dry bulk stocks

China Inflation 2013-07-09Enlarge GraphCentral banks and inflation

What the central bank does is one thing. What the central bank is able to do is another. Our previous article talked about how the interbank repo rates, which are the rates that banks charge each other for borrowing cash in exchange for securities such as government bonds, will likely stay elevated in the short term. But is the central bank able to contain the risk just within the financial sector? Or will the risk spill over into the rest of economy and hurt economic growth? To answer these questions, we should also investigate an indicator that central banks often look at: inflation

Inflation ticks up in June

For June, China’s consumer price index (CPI) grew 2.7% due to higher food prices, while the producer price index (PPI) fell 2.7% year-over-year. The consumer price index reflects the price of goods that consumers in China spend on average, whereas the producer price index reflects the wholesale prices received by domestic producers of goods and services. The producer price index remains weak, although improving from May’s 2.9% decline, as falling commodity prices continue to drag down domestic mining companies.

Analysts widely consider the two indexes because a high inflation rate (although often suggesting strong demand and economic growth) will lower the purchasing power of money and lead to hyperinflation (extremely high inflation that’s gone out of control). This can lead to an economic collapse down the road, because either goods will become too expensive to purchase or money will become worthless. When money is worthless, the financial system collapses.

China 12 Months Best Interest Rate 2013-07-10Enlarge Graph

Inflation and monetary policy

So when inflation is high, central banks can’t loosen monetary policy, which lowers interest rates by injecting more money into the economy. If they did loosen monetary policy, the move would allow more people to borrow more, which would further increase demand for goods and drive prices higher. This was the case back in 2008, when interbank repo rates jumped. As a result, the central bank couldn’t cut interest rates until the end of 2008, by which time the market had already crashed.

Given that both indicators of inflation remain weak or low, the central bank can loosen monetary policy to support the economy if repo rates do rise further. This is positive for dry bulk shipping companies such as DryShips Inc. (DRYS), Diana Shipping Inc. (DSX), Navios Maritime Partners LP (NMM), Safe Bulkers Inc. (SB), and Knightsbridge Tankers Ltd. (VLCCF). A crash like the one we saw in 2008 is unlikely to happen.

For more indicators on how China is doing, or to follow the interbank interest rate, see our Macro Trends page.