The current phase of sub-zero inflation will get over in a couple of months, maybe even sooner given the profligacy in the budget.
The wholesale price index (WPI)-based inflation soared to 12.8 per cent by August 2008. It has now collapsed to minus1.61 per cent. These are the highest and the lowest rates of inflation since the new base came into existence in 1993. The spiralling inflation in the first half of 2008-09, which mirrored the situation in most other economies, was the result of high food and fuel prices and strong demand. Subsequently, inflation started decelerating as the global financial crisis led to shrinking output and declining commodity prices. Some economies have already slipped into the negative inflation zone, and monetary and fiscal policies are working to counter the onset of a deflationary cycle. Inflation in India, too, has entered the negative zone. Does India risk slipping into a deflationary cycle, where falling output and prices feed on each other? After examining the recent inflation dynamics, we believe that this is not the case.
Deflation is the sustained decline in the general price levels measured through an overall measure of prices (WPI, the Consumer Price Index or GDP deflator). It is important to emphasise the word ‘sustained’ as deflation does not refer to a temporary fall in prices, but is a more deep-rooted phenomenon. While inflation reduces the real value of money over time, deflation does just the opposite. It thus transfers the wealth from borrowers to savers. Deflation is a greater concern than inflation as it can lead to a liquidity trap, where monetary policy becomes ineffective in stabilising the economy. This is a situation that many advanced economies, that have policy rates close to zero, are trying to avoid in the current downturn. As the interest rates cannot fall below zero, negative inflation implies that real interest rates cannot be brought down by the Central bank’s measures. Such a situation occurs during intense recession or depression. The two most prominent periods of deflation were associated with the Great Depression of the 1930s and Japan’s lost decade of the 1990s. The term deflation is often confused with dis-inflation. Dis-inflation merely means a slower pace of inflation, in which prices are still rising but at a lower rate. In contrast, deflation means a decline in the price levels.
Deflation is generally the result of a negative demand shock, but it could also be due to a supply shock. Supply-shock deflation can be linked to productivity enhancements or a sustained decline in the prices of commodities like oil. Productivity-driven episodes of deflation are difficult to identify, but are relatively benign in comparison to a deflationary cycle set in motion by demand-contraction. Demand-contraction leads to a fall in prices. Consumers react to falling prices by delaying consumption, which further slows economic activity as companies cut production and wages. This then starts a vicious cycle in which weak economic activity and falling prices feed on each other.
| What’s going up, what’s not | |||
| Inflating Categories | |||
| Major Group | Categories | Weight | Inflation in May ‘09 |
| Primary Articles | Cereals | 4.41 | 12.40 |
| Primary Articles | Pulses | 0.60 | 14.89 |
| Primary Articles | Other Food Articles | 10.39 | 5.87 |
| Manufactured Products | Food Products | 8.78 | 18.18 |
| Manufactured Products | Beverages, Tobacco and Tobacco products | 1.34 | 5.81 |
| Other Inflating Categories | 42.83 | 1.48 | |
| Total Inflating Categories | 68.35 | 5.54 | |
| Deflating categories | |||
| Primary Articles | Minerals — non metallic | 0.19 | -11.21 |
| Fuel Group | Administered Fuel Items | 5.44 | -0.97 |
| Fuel Group | Non-administered Fuel Items | 1.55 | -27.90 |
| Manufactured Products | Basic Metals, Alloys and Metal Products | 8.34 | -13.09 |
| Manufactured Products | Edible Oils | 2.76 | -4.13 |
| Other Deflating Categories | 13.37 | -0.85 | |
| Total Deflating Categories | 31.65 | -7.04 | |
India’s headline inflation started declining from September 2008, as waning external and domestic demand dragged prices down. By June 2009, it turned negative on account of a sharp correction in crude price and its subsequent pass-through to the domestic market. There was also a sharp decline in the prices of many energy-intensive manufactured items, such as metals, chemicals and plastic. However, for the last few weeks, the predominant reason for dis-inflation and the present negative inflation is the high base of last year.
Our analysis suggests that the sharp increase in WPI last year has already seen a correction and WPI is currently below its trend-level. The sub-sector level inflation behaviour offers interesting insights into inflation dynamics. While overall WPI inflation was down to 0.5 per cent in May 2009, the majority of categories in WPI (with a collective weight of 68 per cent) are still experiencing positive inflation. Foodgrains in the primary-articles group and food products of the manufactured-products have the highest level of inflation. The fuel-group, particularly non-administered fuel items (naphtha, furnace oil, aviation turbine fuel), witnessed negative inflation as these are directly linked to global crude prices which saw a massive correction. Administered fuel items, however, saw their prices drop by only 0.97 per cent in May 2009 vis-à-vis May 2008. Metals and metal-related products and edible oils were the other major categories that registered deflation.
In 2003, the IMF laid out certain conditions which expose a country to deflationary risks. Most of them do not hold true for India. In view of the overall global and domestic scenario, credit growth in India during 2008-09 was healthy at 17.3 per cent. In the past three years, growth had been a robust 27 per cent, much higher than the 10 per cent required for a country to be classified as vulnerable to deflation. The growth in broad money (M3) too was 18.4 per cent, almost three times the growth of 6.3 per cent in base money (M0). This too rules out India’s vulnerability to deflation. Another factor that negates the possibility of deflation is that average annual GDP growth in India in the last 3 years at 8.6 per cent has been higher than the average growth of last 10 years (7.1 per cent). This is a benign scenario when compared to the IMF requirement of growth in last 3 years to be two-thirds that of the growth in previous 10 years. As per the output-gap analysis, although the output gap in manufacturing is still negative, its pace of decrease is now slowing. Equity markets have already moved up from their lows. In short, the performance of macro-indicators at large diminishes the risks of deflation. The continuation of negative year-on-year inflation in the coming months would largely be driven by the high base and clearly nullifies the possibility of a deflationary cycle.
Since the consumer-price inflation measured by the CPI continues to be very high, the demand situation is not even close to being threatening. The demand situation is expected to improve with the monetary and fiscal measures taken by the RBI and the government. This is expected to increase prices and stabilise inflation in the positive territory in a few months. Further, as the policy rates are significantly above zero, there is no question of a liquidity trap in India. This will keep deflationary expectations at bay. The seasonally-adjusted annualised-inflation shows that the trend of decline of prices has already reversed. While this will take a couple of months to translate into rising inflation, it unambiguously shows that the period of sub-zero inflation will be a temporary one. The recent fuel-price hike and a consumption-promoting budget will take the inflation out of the negative zone sooner than expected earlier.
A fuller version of this article appeared in Crisil’s Ecoview
The authors work at Crisil
