Economy staring at deflation

With Inflation At 32-Yr Low, Room For Rate Cuts

New Delhi: 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 foodgrains 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. WHAT IS DEFLATION?
A persistent decrease in general price of goods & services. It occurs when the inflation rate falls below zero and stays there for a sustained period
Why Is It Bad? Since the prices of goods are falling, consumers tend to delay purchases until they fall further. This, in turn, leads to lower production, which causes lower wages and demand, leading to further decreases in price. This is called the deflationary spiral, or vicious cycle
Even when interest rates drop close to zero, it doesn't help. Instead, it actually makes things worse as investors opt to hoard money rather than make potentially risky investments
The Great Depression of the 1930s was a deflationary spiral. More recently, Japan entered deflation in the early 1990s and only emerged after over a decade, called 'the lost decade'
Where Should
You Invest During Deflation?
Look for cos whose sales are not affected too much by prices, like giants in consumer goods, healthcare and utilities
Companies which can counter lower prices through higher value-added products or greater economies of scale
Firms with low levels of debt. Cos which had earlier taken heavy debt at high rates see their real cost of debt soar during deflation P 21 Pressure on RBI to cut rates further New Delhi: A recent Citibank report warned that the trend towards falling inflation would weaken economic activity and discourage investments, which would affect the economy in the longer term.
    The fear about investments not materialising 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.
    Demands for the RBI to intervene to induce a further round of cuts in interest rates are bound to mount in the face of the latest data. However, planning commission deputy chairman Montek Singh Ahluwalia said the inflation rate would rebound from its present level. While not ruling out the possibility that inflation could go into negative territory, he maintained it would last for only a few weeks. Hence, he said, it should not be termed as deflation.
    From the aam admi's point of view, what makes the situation worse is that prices of essential commodities like foodgrains are stubbornly refusing to come down.

Montek Singh Ahluwalia