The bush-fire of deflation seems to be spreading rapidly. For one thing, falling prices are no longer a phenomenon confined to the developed markets of Europe and Japan. China too seems to be engulfed by it. Producer prices have been falling three years in a row and now they seem to be spilling over to the consumer prices as well. Consumer price inflation fell to a five-year low of 1.6 per cent on an annual basis in October, prompting a rate cut by the People's Bank of China. The biggest challenge for central bankers now is to fend off falling prices rather than merely try to prop up growth. For consumers in India, tottering for years now under the burden of high inflation, falling prices must seem like a good thing. So what's the fuss all about? The problem is that rapidly falling prices below a certain level could trigger a prolonged recession. One way in which this works is the effect on borrowers and lenders. The real value of debt rises as prices fall - debtors take a hit while creditors gain. For some, this might appear like a zero sum game, with the two effects cancelling each other out. However, as the American economist Irving Fisher pointed out in the 1930s, these effects are asymmetric. Debtors hurt more and cut back on consumption but creditors do not raise consumption by that amount. The net effect is a hole in demand that in turn feeds the deflationary spiral, resulting in the hole getting bigger and bigger. Deflation quite obviously has to be associated with excess production capacity.
But that's not saying much. If indeed excess capacity were the only problem, monetary bosses could simply ramp up their printing machines to increase what we economists call aggregate demand. However Japan's experience over the last three decades and Europe's experience of the last half decade should convince readers that this is easier said than done. It is useful to think of deflation in terms of current and future expectations of prices. If consumers believe that future prices will be lower than current prices, they defer their consumption decision pulling aggregate demand down in the process, leading to falling prices and expectations of further price fall. This keeps the deflation clock ticking. The challenge now is for central bankers to commit to "managed inflation" by signalling to the economy that prices will rise in the future. However, the caveat in all this, as Paul Krugman has argued in one of his lectures at the Massachusetts Institute of Technology, is that while the idea of central bankers promising higher inflation is analytically solid, it just sounds crazy and that might just be a problem. To quote him, "How can we get finance ministers and central bankers, who have spent their whole careers preaching the evils of inflation and the virtues of price stability, to accept the idea that price stability may not be an available option?" Take the case of Japan - concern about the high level of public debt (currently at 240 per cent of gross domestic product) has led the country to consider a second hike in the consumption tax. However, this is just the kind of policy the government should not be taking if it wants to convince companies and households to spend more. A loss in fiscal confidence may actually be called for in the fight against deflation. The other party-pooper, as the European Central Bank (ECB) is facing currently, is that markets price in the impact of an anti-deflationary policy like quantitative easing (QE) much before the actual event. In Europe's case, this has been manifested in sharp fall in yields (short-term yields are negative) and sharp depreciation of the euro, even though the ECB is yet to announce a formal QE programme. If the actual purchase of government bonds falls short of market expectations, yields will start rising again. Thus, the ECB has to ensure that the extent of monetary easing meets market expectations.
Abheek Barua is with ICRIER. Bidisha Ganguly is Principal Economist, CII