Why disinflation doesn’t militate against an investment binge?

By M H Ahssan

It’s a myth that inflation is good for stepping up investment. In fact, given the disinflationary price situation, it makes sense to fastforward capital investments now.

It's generally the case that money can’t buy everything—for instance, what it did ten years ago! Price inflation can and does queer the pitch. It is notable that the inflation rate as measured by the wholesale price index (WPI), has dropped to 0.44% in early March (over the like period last year). It implies that producer prices are now just about flat, year on year.

The drop in the inflation rate has implications for policy formulation, and for investment and consumption behaviour quite across the board. Besides, the price index needs updating too.

The falling inflation rate means that we are in a disinflationary scenario, what with the rate of inflation coming down quite dramatically year-on-year. The sharp drop in global crude oil prices in the past one year seems to have much affected domestic WPI figures. It is true that during the period, retail prices of the main oil products like diesel and petrol have remained rather sticky.

But the lack of sustained price revision—despite record imported costs of crude—appear to have built up inflationary expectations, and which have now thoroughly abated it would seem. In any case, oil price changes do affect—in various degrees—most sectors of the economy. For instance, crude prices heavily impact other commodities in myriad ways, including of metals and chemicals. It is only a fact that the latter two sectors have the most weightage in the basket of commodities that make up the WPI (base year 1993-94). Hence the steep fall in the y-o-y WPI inflation rate. It implies that weighted average producer prices, on the whole, are little changed from last year.

However, there are sectoral differences in price behaviour within the WPI, with food prices, for example, buoyant. So we’re not in a price environment that can be labelled deflationary—characterised by falling prices and output. Yet the drop in the inflation rate, or a regime of disinflation, would change relative prices. For instance, producers may want to decelerate output given the weak trend in prices. The way ahead for policy is to estimate the “sacrifice ratio,” the quantity of output effectively “lost” for each percentage point reduction in the inflation rate.

The ratio actually measures the sum of the differences between the logs of trend and actual output divided by the change in trend inflation, in a given episode of disinflation. It can be deemed as the output loss (read cost) of reducing inflation. Note, though, that it’s not a true cost.

The sacrifice ratio seems to be much in evidence in the high-income mature economies. Hence the call for low, steady inflation rates to incentivise output, efficiency improvement and keep the economic engine well oiled, as it were.

But it is worth finding out whether the sacrifice ratio is indeed a fact in India, and if so, to what extent. The fact remains that since the nineteen nineties, the average inflation rate has considerably declined even as output has surged.

But then, it’s a myth that inflation is good for stepping up investment and therefore for revving up the economic growth momentum. Actually, the opposite seems to be the case as price stability does appear to boost the very process of capital formation. The negative effects of inflation on wage-good prices, savings and investment is a fact. Just as important, disinflation can well accelerate capital formation, by significantly improving the tax treatment of productive equipment by way of increasing the present value of depreciation benefits.

Note that the effective tax rate on new investments in a corporate setting is a function of the present value of depreciation schedules, which, in turn depends on the nominal discount rate. And the prevailing discount rates would willy-nilly fall point for point with the inflation rate.

It would result in the increase in the present value of depreciation deductions on plant and machinery. In recent years there’s been much discussions in policy circles here to step up investment and the coagulation of funds by way of proactive tax incentives and the like. But the point is that disinflation would achieve much the same result!

So, given the disinflationary price situation, it actually makes sense to fastforward capital investments. The Centre has ownership and controlling stake in several large companies and it would make policy sense to boost capital investments in the public sector. It would result in a multiplier effect economy-wide and generally increase productive capacity as well. Besides, the Indian economy is now more globalised than ever, and a domestic disinflation scenario would add to our competitive advantage.

It is true that inflation does transfer real assets from creditors to debtors read borrowers, as the latter need to pay back less in inflation-adjusted terms. And to the extent that disinflation reverses the process, it has its costs.

Whatever its merits in the short run, inflation can hardly be viewed as a desirable long-term instrument of redistribution or of investment and growth. Meanwhile, the base year for the WPI needs to be revised and made up-to-date, and the included range of goods enlarged.