High base, not deficient demand, is responsible.
After several weeks of teetering on the brink of turning negative, the inflation rate measured by the Wholesale Price Index (WPI) finally did so during the week ending June 6. The rate clocked in at minus 1.61 per cent, compared with a relatively high 11.66 per cent during the corresponding week last year. Last year’s surge during June was a reflection of the government’s finally giving in and raising the domestic prices of petroleum products. It is this significant increase in the base that is responsible for the inflation rate finally turning negative and, given the inflation pattern of last year, it is virtually certain that the rate will stay in negative territory for some weeks to come.
One reason why it took so long to become negative was food prices. These have been rising persistently for some months now, leading to a significant divergence between inflation as measured by the various Consumer Price Indices (CPIs) and the WPI, the former putting a much higher weight on food. The week ending June 6 saw a decline in food prices overall, compared to the previous week, but the prices of several items, particularly important pulses like arhar, masur and moong, continued to rise. A deficient monsoon will intensify the pressure, pushing the government onto the back foot.
However, the main concern that has re-surfaced in the wake of the negative inflation number is deflation. When it became imminent some weeks ago, many people raised the spectre of a deflationary spiral. The textbook version of this describes a process in which people decide to postpone spending because they expect prices to fall some more. This translates into a fall in output, lowering incomes and demand even further. The Great Depression certainly played out this way. Given the parallels that have been drawn between the Great Depression and the current economic crisis, the fear was not entirely misplaced.
However, given the GDP numbers for the third and fourth quarters of 2008-09 and the recent turnaround in industrial production, however modest, it is obvious that such a downward spiral is not at work. The inflation number is negative almost entirely because of the inordinately high base of last year. Since then, the prices of oil and virtually all other commodities have fallen sharply. This, then, is negative inflation arising from positive developments on the supply side and should not be any cause for concern. It does not carry specific policy implications, but it does strengthen the case for further rate cuts by the Reserve Bank of India in the next quarterly announcement at the end of July.
Of course, other factors tilt the argument against rate cuts. Signs of stability and even modest revival suggest that the policy measures initiated over the past few months are working and the best bet for monetary policy is to remain neutral. More importantly, oil and commodity prices are on a definite upswing, which could reactivate inflationary pressures sooner than was expected.
