Are we heading towards deflation? - Views on News from Equitymaster

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Are we heading towards deflation?

Mar 20, 2009

Inflation, as measured by the wholesale price index (WPI), fell to 0.44% in the week ending March 7 as compared to 2.4% recorded a week ago. This is the lowest inflation recorded in nearly two decades. The sharp fall in inflation has raised concerns about the Indian economy entering into a deflationary phase. In order to understand effect of deflation on investors, let us first understand what deflation is and what causes deflation. In this article we will give you brief description of deflation, its cause and effect.

What is deflation?
In common parlance, falling prices are referred to as 'deflation'. In economic term, 'deflation' occurs when the inflation rate falls below zero percent, resulting in an increase in the real value of money. However, a one-time fall in the price level does not result into a deflation. It takes a while to conclude that economy is in deflation. The time period is generally 12 months.

What are the causes of deflation?
In the long run deflation is a monetary phenomenon. However, in the short run, many factors can push the economy toward deflation. There are four basic causes of deflation which can be listed as follows - decreasing money supply, increasing supply of goods, decreasing demand for goods and increasing demand for money.

The most common factor is a negative shock, which induces decline in consumer confidence that in turn affects aggregate spending. This fall in spending leads to slack in labor and product markets. As a result unemployment rate increases and capacity utilisation declines which cause the inflation rate to gradually decline over time. Another type of factor is a positive shock to supply in the economy. For instance, a positive shock to labour productivity will put downward pressure on prices. This occurs because nominal wages and salaries are slow to adjust to unexpected changes in output per hour. With output per hour rising faster than wages, unit cost of labour declines. In competitive markets, this induces firms to reduce their product prices, and the increase in general price level tends to slow down.

How does it affect investors?
Falling prices might seem as good thing but if prices keep going down then people start deferring their buying decision as this offers them the incentive of lower prices in future. They can get cheaper items by prolonging their decision cycle. And when this effect starts dragging on for too long, companies' profits start declining. The excess supply in the economy forces companies to sell their products at lower prices cut back inventory, reduce employee wages, lay off workers or at times even shut down production facilities. The economy enters into a spiral where people virtually stop spending their money because their economic future seems uncertain and unemployment increases as the economy ceases to expand further.

In such scenario equity prices start declining as investors get rid of investments that do not offer good returns. However, bonds temporarily become more attractive as the government starts lowering interest rates to stimulate the economy and catapult demand.

CPI vs. WPI
The current scenario is clearly not indicating that we are heading towards deflation. Firstly, the index which is being used to measure inflation is Wholesale Price Index (WPI) which does not give correct picture of inflation at the consumers' level. Secondly, the Consumer Price Index (CPI) is hovering at around 10%. Thus there is a clear mismatch between the actual level of inflation and the yardstick being used to measure the same.

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