From inflation to deflation?

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In August 2008, grocery prices soared and inflation ripped through the roof to breach the 12-per cent mark, sending shivers through consumers. We continue to be a worried lot even now – but for a different reason. This time around, we are nervous not over skyrocketing inflation, but its slide!

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For the week ended March 7, inflation fell to a 30-year low of 0.44 per cent from the previous week’s 2.43 per cent (4 per cent in January). But why worry about falling inflation, after all aren’t cheaper goods what we all want? Here is some food for thought.

While we would otherwise have cheered falling prices, what’s worrisome is that the current dis-inflationary environment is a fallout of the drop in commodity prices, rollback in production and weakening demand. Such a sudden and frenzied fall in inflation numbers brings to fore another worry, namely Deflation.

What’s Deflation?

To put it in simple words, deflation connotes a contraction in the general price levels. And, since the Wholesale Price Index (WPI, an indicator of price change at the wholesale level) has been falling week after week, economists now see possibilities of the inflation number (price growth) turning negative in the coming months.

Inflation rate heading towards zero

It merits attention that the current sharp fall in inflation is an outcome of the correction in crude oil and commodity prices in the global markets and the subsequent price corrections in the domestic market.

Though food grain prices are still holding high, vegetable prices have gone down on lower diesel prices. The decline in prices of food articles, fuel and metals has pushed the WPI to a low never seen in recent times.

'Inflation not a concern for next few months'

To economists, deflation is even more worrisome than inflation because it reflects too little money chasing goods and services. When prices start falling, a vicious cycle of lower spending and lower demand sets in, hampering growth.

This is because expectations of falling prices usually trigger a further fall in demand – after all why buy when prices are going to get cheaper one month down the line?

Inflation rate at an all-time low of 0.44%

And as consumers defer spending, manufacturers cut production, workers lose jobs and household incomes fall. This, in turn, leads to drop in demand and a further fall in prices.

Cascading effect

Deflation can have a far-reaching impact on the economy. For starters, most companies will be forced to sell their products at reduced prices, which means their sales and profits may soon start declining. And we know what companies do when profits get hit – cut costs by cutting production and jobs.

Deflation threatens jobs of not just the workers on the factory floor but those in administration too. And for those that manage to survive the layoffs, paycuts are a worry. One devil will lead to the other – falling salaries will increase the burden that you carry in the form of various loans – home/car/personal.

While on one side the income stream will be cut, on the other side the value of debt will inflate as money value increases. Getting confused? Sample this. In inflationary conditions, you will earn more and repaying debt will not be a problem.

Suppose, with Rs 100 you can buy 10 apples under inflationary conditions, one year later with that money you may only be able to buy five apples. In an inflationary environment, spending today makes more sense than saving up that money for the future. In a deflationary environment, postponing spending makes sense.

If you are a salaried employee, deflation also has more direct implications for your pay cheque. Government and select private sector employers usually have a Dearness Allowance (DA) component in pay. That is your employer’s effort to compensate against price rise and is normally a certain percentage of your basic pay.

As price levels increase and Consumer Price Index surges, the government increases the Dearness allowance to both serving employees and pensioners. Following this, private organisations also revise DA. On deflation setting-in this component will be the first to get knocked off.

Souring investment

Deflationary conditions also have implications for your investments. During extended periods of deflation, equities as an asset class lose their significance as corporates deliver poor results.

Gold may also lose its sheen as it tends to be held as an inflation hedge. Interest rates on fixed deposits on other safer options too may trend down, as interest rates ease off.

Room for cheer

If reading about all this has left you troubled, here’s some reason to cheer. What offers relief, at least for now, is the high reading on the CPI, the Consumer Price Index.

The CPI for industrial workers, a reflector of retail prices at the end-consumer level, held firm at 10.45 per cent in January, and for that matter it actually went up from 9.7 per cent in December 2008. So what is behind the fall in WPI?

The plunge in WPI was mainly driven by the fall in prices of industrial commodities and raw materials. Oil fell from its high of $109 in September 2008 to a low of $37.4 in January 2009. That the Reuters CRB Commodity Index plunged 27 per cent from its highs in September 2008 and hit pre-2007 levels in end-December 2008 may help put it in perspective.

With the current bout of low inflation in India driven mainly by the commodity price correction globally, most economists feel that what we are liekly to see in the coming months is not the classic deflationary situation.

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We can also take respite from the fact that globally commodities are beginning to look up now, showing signs of revival as the dollar slides lower every day – crude oil has surged 11 per cent in the last week. Gold too has rebounded and hit $962 per ounce this week.

While deflation has not officially set its foot in India just as yet, investors can play the deflation theme by looking out for companies that are low on debt and have sufficient internal accruals to pay up debt obligations.

You can look out for companies that have relatively higher pricing power or are established volumes plays.

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