‘D’ day for Indian economy

D is for Doom. D is for Death.

D is also for Deflation, the second most dreaded ‘D’ word in economics after Depression. Deflation occurs when the inflation rate falls below 0%. Combine that with negative output growth and you get a deflationary recession or depression. Thankfully, deflation is rare and depression rarer still in economic history.

Why then has the chief economic adviser (CEA) recently invoked the fear of deflation in India?

First, a brief technical tour. There are different ways to measure inflation in India—the Wholesale Price Index (WPI), the Consumer Price Index (CPI), and the GDP deflator. The WPI for all commodities did show a month-on-month (m-o-m) and year-on-year (y-o-y) decline in July of this year. The index peaked in August of last year, and has been fluctuating in a narrow band since. This is not surprising since the price of the Indian crude oil basket (which influences several items that make up this index) made a broad top for the one-year period ending by about August 2014 and had four back-to-back months of double digit declines after that. It is likely, therefore, that the August data will also show a y-o-y and m-o-m decline in WPI. Thereafter, the y-o-y series will become unpredictable (and possibly not in deflation) unless oil continues to fall.

The CPI series has been declining, though still significantly positive, and showed an unexpectedly sharp fall in July to 3.8% y-o-y. The GDP deflator, which you can think of as a weighted average between WPI and CPI, is hovering around zero. Some consider the deflator a superior inflation measure since it represents all goods and services in the economy. However, it is only released quarterly with the GDP, unlike the monthly WPI and CPI statistics. Most central banks prefer a consumer inflation index because they are more interested in inflation expectations (the future of inflation) being anchored and low: wage setting in the economy and the allocation of savings is dependent on the inflation that consumers perceive.

And so, CEA Arvind Subramanian, using the GDP deflator as his preferred measure, is not wrong in saying that “we are closer to deflation territory”. This is an accurate current statement. However, as the y-o-y effects roll off, it may be a rather poor reflection on the future of inflation. Given 7% real GDP growth, and a small and moderating output gap, it is extremely unlikely that India will be in sustained deflation. The statement must, therefore, be read less as an economic statement and more as a political economy one. The CEA is attempting, again, to convince the Reserve Bank of India (RBI) that real rates for the economy are too high. Real rates are the lever that central banks use to target inflation.

It is becoming clearer with each passing month this year that RBI may indeed be behind the curve. Depending on which measure of inflation you use, current real rates range from 3% to over 7%, with some likelihood that they will go higher still until the y-o-y effects wear off. Why then has RBI been hesitant to cut rates more significantly?

In March, RBI contractually agreed with the centre to an inflation target (CPI) of lower than 6% by March 2016 and 4% +/- 2% thereafter. So, one reason RBI has not reduced rates is to ensure that its targets are not missed (will that have to be at the price of growth in 2015?). RBI governor Raghuram Rajan also comes from the school that believes that once the back of inflation is broken (Paul Volcker style) it is much easier to structurally maintain a lower inflation rate in the economy. This works well in a normal world, but in a world that has tepid GDP growth with many economies in deflation, there is clearly a risk of overdoing it. The other reason is that RBI is worried about liquidity (out) flows if the US were to raise rates, which appears very likely in the next few months. These flows would potentially put great pressure on the rupee and if the rupee were to fall substantially, it would be a source of inflation. The risk to this is that the markets are widely expecting this and unless the Fed raises rates at a speed greater than what the markets believe (seems unlikely with last week’s US unemployment number) the event may have less impact.

Putting this all together, it looks rather likely that RBI will reduce rates in September (the Fed meeting precedes the RBI’s by two weeks). Rajan pretty much indicated this in his public comments on the sidelines of the annual Jackson Hole, Wyoming, conference. Whether they will continue to reduce rates by a total of 50-100 basis points over the next 3-4 quarters remains to be seen. If they don’t, it may well be a case of operation successful (inflation), patient (growth) dead. Deflation, though, is unlikely.

P.S. “The importance of money flows from it being a link between the present and the future,” said John Maynard Keynes.