Moderate rate of inflation, which measures increase in prices, is good for any economy. If inflation is within a range of two or three per cent, it provides an incentive to the producers to remain in the business and earn good profit. The current rate of inflation touched a 30-year historic low of 0.44 per cent for the first week ended March 7, 2009—the lowest since 1977-- due to a high base in 2008 and a fall in prices of primary articles. Food prices, however, continued to be high, with food grains roughly nine per cent costlier than a year ago, reinforcing a cruel paradox for consumers that they hear about zero inflation but face high prices when they buy their groceries. Economists expect inflation to turn negative in the coming days though the Government allayed fears of the country sliding into a deflationary phase.
Negative inflation will occur mainly because of the high base last year in which inflation had touched 12.91 per cent on August 2, 2008. During the corresponding period in 2008 inflation had started rising. Therefore, the base effect will become stronger from here on and inflation will touch zero by March-end. This could be India’s first deflation since March 1977.
However, the Planning Commission Deputy Chairman Montek Singh Ahluwalia has allayed fears of the country sliding into a deflationary phase and termed the current low level of inflation as good for the economy.
The Government is committed to switching to a more holistic inflation index in July 2009, that incorporates the service sector, polls retail prices and bring the base forward to 2004-05. The under-reporting inherent in an index of wholesale prices — that ignores over half the country’s economic activity — and from a base year as distant as a decade-and-a-half away was in desperate need of correction.
The Factors
Inflation, which touched a peak on 12.91 per cent in August 2008 mainly due to rising oil and commodity prices, has been on the decline in the aftermath of the global financial meltdown that showed sharp slippages in prices around the world. Between March and August 2008, the rate had climbed from six per cent to over 12 per cent before falling back again to six per cent in December 2008.With stimulus packages is difficult to come by for the next two months due to the model code of conduct, monetary measure is the only option. It is expected that another 100 basis point cuts in the Repo and Reverse Repo Rates, to 4.0 per cent and 2.5 per cent, respectively, by mid-2009, due to rising real interest rates and as Monetary Policy is the only tool to offset weakening demand until the 2009 general elections.
The reason of a drastic fall in inflation from 2.43 per cent previously is basically led by the declines in food, non-food, fuel and electricity prices. A high base effect has also precipitated the fall. For a consumer the fall in food prices will be visible only when the wholesale price reductions are transferred to the consumer price. Till now the consumer price index is almost the same as what it was at the inflation level of 11 per cent--12 per cent. It is also expected that the Commodity Price Index (CPI) to get to a moderate level of four per cent only by fourth quarter of 2009. An ideal rate of inflation for a growing economy is expected around three per cent leaving enough space for the economy to grow at a faster rate. At present the country’s economy is in stagflation where the inflation is declining but the economy is not growing at the desired level. Once we start growing at a level of 6 per cent - 6.5 per cent and inflation figure stablises around three per cent, our economy will be back in an ideal growing economic situation.
Fall in the Wholesale Price Index (WPI) falling by one point to 226.7 for the week ending March 7, 2009 — the same level at which the index was on March 29, 2008 — it now means the year-on-year inflation rate will become zero by the last week of March even if the index for the current year falls no further. As most commodities are becoming cheaper with every successive week in the recent past, deflation is expected to set in even before that. The rabi harvest should see a drop in foodgrain prices too, and that will only accentuate the trend. If deflation lasts for some time, as seems possible, it would be a new experience for India. Japan went through a decade-long deflation in the 1990s, termed as the ‘lost decade' for that country. The Great Depression of the 1930s was one example of a deflationary spiral.
When inflation is falling because prices are falling, it can be technically called deflation. But it is more important. A structural deflation would mean no demand and no growth. However, India is growing, even if it may be only six or 6.5 per cent. So it is more a statistical deflation. If you take a two-year horizon there would be a price growth of three to four per cent. The year 2008 was an abnormal year when prices soared very quickly, and now, in 2009, we see a huge fall. So there is a spell of negative inflation year on year which is not structural deflation. The fall in inflation to below one per cent does not signal the onset of deflation and that it could be the result of the high base effect of inflation. Inflation had stood at 7.78 per cent during the corresponding week of March 2008.
Is WPI Correct Indicator of Inflation?
An important question being raised is whether the inflation rate announced by RBI is realistic or not? The world over, central banks rely on the Consumer Price Index (CPI) to gauge inflation and set the Monetary Policy but India uses Wholesale Price Index (WPI) as benchmark to gauge inflation. This is because the CPI basket is the genuine consumption of some households in India, while the WPI basket lacks such a foundation. WPI does not give a complete picture of inflation as the items included in the WPI contribute only 48 per cent of the GDP, i.e. manufacturing sector only.
Even in manufacturing sector, WPI does not represent the changed structure of economy. For example, it does not cover PCs or Consumer Durable products, whose sales have surged over the past several years. Also, their prices have dropped considerably. Not many people were using mobile phones or PCs in 1993-94. But, at present mobile phone users have alresdy crossed 100 mn. This can be attributed to the ongoing structural changes, with consumption-led boom being the key highlight.
Worrisome Point
What is particularly worrisome is that given the present inflation and the interest rates being charged by banks, the real rate of interest in the economy is at double-digit levels. The banks must lower the lending rates of single-digit levels, if economic activity is to be stimulated.
The fear about investments not materializing is aggravated by the fact that nominal interest rates are at relatively high levels. When prices are falling, this means the real interest rates — the difference between the nominal rate and the rate of inflation — are becoming very high for producers, making it unviable for them to raise funds. Demands for the RBI to intervene to induce a further round of cuts in interest rates are bound to mount in the face of the latest data.
Technically, the central bank can drop its overnight interest rates to zero without making money free for banks. Rate cuts by the Reserve Bank of India have been trailing market expectations and the clamour for another one is rising. Zero inflation gives RBI the space to pump more money than what the government’s spend-and-borrow budget is sucking up.
The problem appears to be that the RBI is new to counter-cyclical monetary policy. Until now all it worried about, and devoted its entire firepower to, was the rupee’s exchange rate — and how to handle the consequences of its actions on the forex market. Now even without doing anything on the forex market, market conditions require the RBI to move.
In view of the evolving situation, the banks must shed their conservative stance with regard to lending to corporates and consumers. In fact, the Reserve Bank of India (RBI) and the Government should embolden and incentivise the banks to direct resources for productive purposes.
To sum up, it can be said that, controlling inflation is really a tough task for RBI as well as Government due to global integration of the economy and prices being determined by global demand and supply rather than by local demand and supply situation. But application of traditional measures of controlling inflation coupled with policy initiatives by the Government will definitely help make life of common man less difficult than it is at present.
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