Not a case of deflation

The mere fact of negative inflation rates does not amount to the malaise of deflation

With the year-on-year inflation rate measured by the Wholesale Price Index (WPI) dropping to near-zero, concerns about the Indian economy heading into a deflationary phase have begun to spread. It is almost certain that the WPI inflation rate will turn negative in the next few weeks and stay that way for several weeks after. If deflation is defined simply as a negative rate of inflation, then the economy is indeed headed for deflation. However, the concerns stem from something deeper than a mere numerical definition. It is important to understand the malaise before deciding whether India and, for that matter, the rest of the world, is in impending danger of being afflicted by it.

When the prices of commodities begin to drop, the logical response of consumers is to postpone whatever purchase decisions they can, under the expectation that they will be able to buy things cheaper a little later on. Deferment of purchases results in an excessive build-up of inventories, which in turn causes producers to cut back on production. Thus, the signal from falling prices is transmitted to production decisions, setting a downward spiral in motion. The larger the share of products whose consumption can be deferred and which can be held as inventory in the aggregate consumption basket, the stronger this force will be. Reinforcing the problem is the fact that producers typically have contractual arrangements with workers and other input suppliers, which prevent them from reducing their costs in a hurry, even as their revenues are falling. This puts pressure on margins, causing further distress which could result in layoffs and termination of supply contracts. On this line of reasoning, the critical symptom of deflation is a rapid decline in the prices of products such as garments, consumer durables, automobiles and so on, which is not commensurate with a decline in the costs of production of these items.

This is not the case in India and elsewhere, at least for now. The zero and negative inflation rates are largely the result of the dramatic decline in energy and commodity prices over the past year. A year ago, crude oil prices were in the region of $100/barrel, from which level they climbed to almost $150 in July. Along with this, the prices of several commodities, including food items, were also climbing rapidly. For the most part, these prices have crashed, allowing producers to reduce costs. Sluggish demand across the board has, of course, forced producers to reduce their selling prices. However, the weekly WPI data suggest that the main reason for the fall in the inflation rate is lower energy prices. The prices of manufactured goods, in general, do not appear to be declining; if they are, the drop is certainly not as sharp as to indicate the kind of spiral described above. In fact, in the January numbers for the Index of Industrial Production, consumer durables showed an increase in output, however small, a pattern inconsistent with the deflation hypothesis. Finally, since the process is significantly dependent on expectations of prices continuing to fall, the large increases in liquidity induced by monetary actions over the past few months cannot but spur expectations of a return to positive rates of inflation in the not too distant future. In sum, the mere fact of negative inflation rates does not amount to deflation.