India’s economy may be staring at deflation

By Swati Reddy

India is staring at deflation, or negative inflation, with the official inflation rate this week falling to 0.44% __ the lowest since 1977. Food prices, however, continued to be high, with food grains roughly 9% 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.

With 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. Toi had pointed this out last Friday.

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. At present, most major economies are witnessing disinflation __ a lowering of the inflation rate __ and some have also seen deflation kicking in. Japan and China have already reported negative inflation rates in the latest data and there are signs that the US, too, could be heading the same way.

While a fall in prices may sound like good news to most laymen, economists see this as an ominous sign of a collapse in demand in the economy. A recent Citibank report echoed this concern in the Indian context saying that the present trend of decline in inflation was not because of any improved efficiency in the economy but because of falling demand.

The report warned that this trend would weaken economic activity and discourage investments, which would affect the economy in the longer term.

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.