Are we moving from Inflation to Deflation ? ? ?

In the past one year, if one were to look at the chart of Indian Inflation figures, you may believe it to be that of a stock! From a level of near 4% in last January 08, inflation ‘rallied’ to 12% plus in August 08 and then ‘crashed’ to the recent low of 3.92%.

On January to January basis, we can say ‘we are back to square one’. But then that is hardly true.

One of the reasons for Inflation being lower may be because of the ‘base effect’ (corresponding figures being compared of earlier period are higher, so the increase from that level seems less).

When the inflation rate falls from 12% to 4% it does not mean that prices have come down. It only means that the ‘rate of increase’ of prices has slowed down.

In the normal case, inflation rates of 6-7% are considered acceptable; as such normal rates induce the producers of goods to produce goods in expectation of a reasonable profit.

But when inflation rate falls it gives lesser incentive to producers of goods and services. Thus rapidly falling inflation may not be a good thing. And worse of it would be a deflation- an actual fall in the prices of goods.

According to Wikipedia, ‘Deflation in economics is a persistent decrease in the general price level of goods and services, when inflation is below zero percent’.

Thus, when prices start to fall because of lack of demand, they can go well below the cost it takes to produce products. Companies have no alternative than to cut back production and lay off a lot of workers. That cuts demand more which leads to reduction in economic activities and unemployment. You get this vicious downward spiral in prices.

For a couple of decades, Japan witnessed deflationary tendencies and the interest rates steadily fell to near zero levels and remained there for a long time. Even now the interest rates in Japan are near zero. Japanese economy has not witnessed growth due to this fact. In the United States, the worst period of deflation was the great depression of 1929.

The Fed's attention to the rising threat of deflation is encouraging. The central bank has pumped hundreds of billions of dollars into the financial system to try to spur lending and support spending and prices.

While the Indian Government may be happy (in a political sense) to control and bring down the inflation back to 4%, it will be important to ensure that this rapid fall in inflation does not lead to an uncontrollable situation towards deflation.

As between, inflation and deflation, a higher inflation seems to be a better ‘evil’ to live with.

And the world economic recession is not going to help. In fact, going by the recent announcements by major economic powers, including the US, it seems that the ‘west’ is moving away from ‘globalization’ and ‘laissez faire’ and latently following protectionist measures – something for which these same economic super powers criticized developing countries like India!

I SHALL APPRECIATE YOUR COMMENTS - LET THIS BE AN INTERACTIVE FORUM !!

CA Rajiv D Khatlawala
Head of Research and Training
Jhaveri Securities Ltd.