DEFLATIONARY TREND IN INDIA-- ECONOMICS USEFUL FOR RBI /IBPS / SBI /SSC

DEFLATIONARY TREND IN INDIA

       Deflationary trend is continued for tenth month in a row with the whole-sale price index (WPI)-based inflation plunging to a historic low of (-) 4.95 per cent in August on cheaper commodities. But for onion and pulses, wholesale prices of most of the food articles either declined or showed a very marginal increase during the month. Deflation occurs when the inflation rate falls below 0%. Arvind Subramanian, chief economic advisor, had recently warned that India may face trouble due to deflation.

       For a long time, India faced the ugly problem of high inflation – the rise in prices over time. Costs jumped at a fast pace month on month. This forced the Reserve Bank of India to maintain a high-interest-rate policy. Now, the problem has reversed. For the past five months, inflation has been in the negative zone. The gap between input price captured in Wholesale Price Index (WPI) inflation, which is also affected by inflation in tradables, and Consumer Price Index (CPI)-based inflation has been widening. The gasp partly reflects the bigger and faster decline in WPI inflation, thanks to the slump in global commodity price. However, the pace of the pass-through to retail inflation has been slow and the magnitude less than desired. RBI sticks to CPI inflation and is used for monetary policy framework.

      Economists have traditionally distinguished between two types of deflation, one that emerges from the supply side due to higher productivity and that which emerges from the demand side since nobody is buying. Deflation captures a significant shift in consumer behaviour, including postponement of spending in anticipation of lower prices. The last time India saw such a sharp divergence between its two main measures of inflation was after the global financial crisis in late 2008. Wholesale price inflation was at least five percentage points lower than consumer price inflation for five quarters in a row. RBI was then focused on wholesale prices as its main policy target. It kept interest rates too low even though consumer prices had begun to accelerate, which was one reason why India faced an inflation crisis over the next three years.

What is deflation?

       It happens when prices actually fall for a long period of time and it is not a position that any economy would like to be in. Deflation usually moves hand in hand with economic slowdown, lower productivity and loss of jobs. Just like how inflation decreases the value of money, deflation increases its value. This incentivizes people to save money to buy later when goods are cheaper, which, in turn, leads to further slowing of economic growth. During deflation, value of money increases and goods are cheaper but one may end up earning less because of the slowing economic growth.

            Just like inflation, deflation can be a continuous cycle. When prices continue to fall over time, consumers can withhold spending money. This is because they wait to buy the goods or services at a lower rate tomorrow. This means demands continues to fall, leading to further deflation. A fall in sales is not good for company profits. As a result, companies too withhold investing in new projects. All this leads to a slowdown in the economy. Countries often struggle to get out of this deflationary spiral. Japan, for example, has struggled with deflation for nearly a decade. This has kept its economic growth depressed. Classical economists believed that deflation is a monetary phenomenon, that is, it is affected by the demand and supply of money. If the supply of money is less than the demand, then the value of money increases and one needs less of it to purchase other goods and services – which means that prices of goods are coming down. The other school of thought, however, believes that deflation occurs because of over-production or a fall in the aggregate level of demand in that economy. That is, when the supply of goods in services is greater than the demand for them, it results in mass production – leading to a fall in prices.

            Historical cases show that disinflation occurs as a result of the combination of a slump in demand and monetary factors,  that is, excess production happens along with a decrease in money supply, as had happened in the case of the Great Depression in the US and Japanese deflation of 1990s. During the Great Depression, there was severe deflation; it had moved into double digits. Japan has been struggling with deflation for the past two decades. Only recently did its Prime Minister, Shinzo Abe, declare that the period of deflation has come to an end and that economic recovery is on its way. A positive impact of deflation is increased export competitiveness as most other economies are in an inflationary trend. Japan has benefited from competitive exports in the past decade or so. Unlike disinflation, deflation is disliked for obvious reasons. But bond markets actually might do well even in times of deflation as people want to invest in safety.

            The biggest difference between disinflation and deflation is that in case of the former, prices don’t fall. India is currently witnessing disinflation – the rise in prices has slowed down significantly as compared with the previous year. Unlike deflation, disinflation is considered a positive sign and capital markets, especially the bong markets, tend to react positively to this trend. But disinflation without economic growth can be a cause for worry.

Measuring inflation

            There are different ways to measure inflation in India – the Wholesale Price Index (WPI), the Consumer Price Index (CPI), and the GDP deflator. The WPI for all commodities did show a month-on-month (m-o-m) and year-on-year (y-o-y) decline for the past 10 months. The index peaked in August of last year, and has been fluctuating in a narrow band since. This is not surprising since the price of the Indian crude oil basket (which influences several items that make up this index) made a broad top for the one-year period ending by about August 2014 and had four back-to-back months of double digit declines after that. The CPI series has been declining, though still significantly positive, and showed an unexpectedly sharp fall in August to 3.7% y-o-y.

            The GDP deflator, which you can think of as a weighted average between WPI and CPI, is hovering around zero. Some consider the deflator a superior inflation measure since it represents all goods and services in the economy. However, it is only released quarterly with the GDP, unlike the monthly WPI and CPI statistics. Most central banks prefer a consumer inflation index because they are more interested in inflation expectations (the future of inflation) being anchored and low: wage setting in the economy and the allocation of savings is dependent on the inflation that consumers perceive.

Impact of deflation on economy

            The most taxing effect of deflation is unemployment. When the overall price level falls, then people stop buying goods in the anticipation that the prices will go down even further. As a result, the demand comes down drastically – increasing the inventory build-ups and cut-downs in production, and causing companies to lay off people. In fact, unemployment soared to over 25% in the US during the Great Depression. To prevent deflation, two mechanisms are available with the governing and regulatory bodies. They can either give an upward push to the aggregate demand by increasing government spending or they can increase the money supply by decreasing repo rate and cash reserve ratio (CRR).

            Most economists believe that handling deflation is even more difficult than inflation. Both the measures that are used to tackle deflation – increasing government spending and/or increasing money supply – have certain limitations in terms of their application. The government cannot keep on increasing its spending because it has certain fiscal constraints. A very large fiscal deficit is not sustainable for any economy. Also central banks cannot increase money supply forever. In case of inflation, reducing money supply is more straight forward as the repo rate and CRR can go up indefinitely but in case of deflation when they have to be trimmed, they cannot go down to/below zero. Hence, all these problems make deflation a more grave economic trouble.

            Deflation has hit countries in Europe and Japan. Even in Asia, seven out of 10 countries excluding Japan are facing deflation. India has now joined this list after reporting a fall in wholesale prices. The key reason for deflation is the fall in global commodity prices. After years of high inflation, the fall in prices could very well help improve demand for goods and services in India. One of the RBI’s key responsibilities is to keep inflation in check. To do so, it tweaks interest rates. By increasing lending rates, the RBI aims to make loans costlier and thus, discourage borrowing. This, in turn, is expected to discourage spending. As people spend less money, prices stop rising and inflation moderates. Deflation, in contrast, gives the central bank room for cutting interest rates.

Five things to know about deflation

1.     An economic condition where the average price levels are lower than the price levels witnessed during the previous year as the inflation rate turns negative.

2.     The most common cause of deflation is a reduction in spending by companies or individuals leading to low demand for goods and services.

3.     Deflation affects the pricing power of companies, erodes profits and forces them to lay off employees, which leads to increased unemployment.

4.     Governments and central banks worry about the impact of deflation on employment and wages, and tend to increase spending to encourage demand revival.

5.     The problem in many economies is despite keeping the interest rates low and government spending, there is deflation and weak demand.