Deflation: When Inflation Makes an Ugly U-Turn

16 11 2008

 

In India, we have seen only inflation. The rate of inflation goes up or comes down. But prices of all things going down, all at the same time, has been just a dream.

 

In the first half of 2008, the inflation rose steadily on the back of high crude oil and food prices. It touched double-digit inflation and rose to nearly 13%, before slowly declining. Indian Government and the RBI have been taking all the steps necessary for bringing down inflation through various fiscal and monetary steps, all the while blaming global factors for the high inflation. Even the most optimistic economic analysts, did not expect the inflation to come down to single digits before the end of 2008.   Omkar Goswami, in a column as recent as 19 September in Businessworld said

 

Inflation is unlikely to be in single digits by the close of 2008-09. That’s what the data suggests. He qualified it by saying that “My take is that unless there is a spectacular fall in prices in the coming months, we won’t see 8 per cent point-to-point inflation by end-March 2009. It is more likely to be around 10-10.5 per cent — falling, but still in double digits. The moral of this story: Be hopeful, by all means. But don’t ignore the data.”

 

In two months flat, he has been proved wrong. This week’s inflation figure is already single digit 8.98 %. It is a single digit figure, in spite of the fact that the administered prices of petrol, diesel have not been reduced. The fact is, there has been a spectacular fall in prices of commodities worldwide, particularly, metals.

 

If you set out to tame inflation and you achieve it sooner than expected, you should be rejoicing. Yet, the government and the RBI are not. Instead, they are worried about the fact there is a danger of Indian economy swinging towards deflation, much like the rest of the world.

 

What is deflation? The phenmenon of deflation is said to have occured when prices start declining over time. This is the opposite of inflation; when the inflation rate (by some measure) is negative, the economy is in a deflationary period.”

 

Deflation can occur because of a combination of four factors:

 

  • The supply of money goes down.
  • The supply of other goods goes up.
  • Demand for money goes up.
  • Demand for other goods goes down.

 

The liquidity squeeze in the economy has caused money supply to go down. In October, many goods supply have gone up and demand has fallen considerably. Automobiles, steel, cement, housing all have had considerable demand slowdown and inventory build-up in the last couple of months.

 

Deflation is painful because “in deflation [there’s] a declining spiral. Businesses make less profit so they cut back [on] employment. People feel less like spending money. Businesses then don’t make any profits and everything works itself into a declining spiral.” Deflation also has a psychological element as it “becomes rooted in peoples’ psychologies and becomes self-perpetuating. Consumers are discouraged from buying expensive items like automobiles or homes because they know those things will be cheaper in the future” says Colin Asher, an analyst with Nomura Securities. This kind of a deflation happened during the Great Depression in the USA during 1929-1933.

 

The managers of Indian economy seem to have sensed a threat. The RBI has already taken several steps to ease money supply. The Finance Minister is urging all the PSU banks to lend more money to spur demand. The central government employees have been given wage arrears based on the sixth pay commission scales. It is possible that the Indian government like their Chinese counterpart may announce some fiscal stimulus package.

 

If the above measures click, then it is possible that like 2007, India will have low inflation and reasonably good GDP growth.  It is also possible, that due to the increased money supply inflation goes up, but the growth does not happen, leading to stagflation. There is also a remote possibility that none of these measures work and the overwhelming impact of the global factors lead to a deflationary period in the Indian economy.

 

 

The trouble is it is very difficult to read the onset of deflation early. It is easy to get monetary and fiscal measures wrong on both counts –  trendspotting and timing.

 

 

– G. Mohan

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2 responses

16 11 2008
Dhruba

Nice article.

18 11 2008
Venkat Subramaniam

Taking a cue from inter-linkage between growth and inflation in your article;
I will make an attempt to link the terms ‘growth’ and ‘creation of value’ purely from a conceptual point of view (instead of getting into the theory of Economics which I am not qualified to).
Growth in the real sense of the term would mean that there has been value creation and value percolation across groups, and across different strata of the society. Hence the aspect of value percolation has a greater significance when we talk about ‘Growth’ much more than the aspect of just ‘Value Creation’ for a select few.

Notwithstanding the fact that Pareto Rule applies in all walks of life; 20% of the people account for 80% of the world’s wealth and vice-versa; there would be a certain amount of skewness with respect to the percolation of the value created; still real growth has the ability to go beyond this skewness.

Any growth will be accompanied by demand for goods and services, which will result in demand exceeding supply for a certain period of time, resulting in prices going up (inflation). However, what is more important is to see who the beneficiaries of this inflation are. If the beneficiaries are spread across a larger population across different income group levels, then chances are such an inflation would have enabled a larger section of the population to move a peg higher in terms of educating their progeny, better hygiene, and hence a better tomorrow for the next generation. This will build the framework for the next level of growth. This would be a good inflation to have.

On the other hand, if the beneficiaries of the price rise (inflation) are a select few then such growth will have sudden turbulent manifestations (like the recent sub-prime crash) decimating both the good and the bad along its way.

Hence this sudden shift from inflation to deflation; and a very slow recovery process, since the good in the system has also been destroyed.

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