False spectre of deflation

False spectre of deflation

With inflation close to double digits in India, the Western debate on deflation literally seems a world away.

Until last month, this debate was academic in the West, too. But ever since the US Federal Reserve “downgraded" the US economic outlook and resolved to keep pumping cash into the financial system on 10 August, the thought of prices going down has turned into palpable fear. Investors hurriedly sold stocks after they heard what the Fed had to say. Pimco, the world’s second largest bond investor, predicts a good chance of deflation and is organizing its portfolio accordingly.

The deflationistas tell a scary tale. Low growth and employment in the US, sharply reduced government spending in Europe and a sputtering Chinese economy, all point to a drop in aggregate demand. That suggests spare capacity in the global economy, which can drive prices down. Consumer price inflation in the US touched a dangerous low of 0.1% in June.

But that’s hardly the whole tale: The rest of it, we think, actually indicates inflation.

First, though there’s falling aggregate demand, supply or capacity is also looking weak: Factory output in India and, more importantly, China is cooling down, meaning there aren’t that many goods for money to chase. Last week, the US reported increasing producer prices, while UK consumer price inflation continues over 3%. A drought in Eastern Europe has already sent food prices soaring.

Second, even if, say, Chinese manufacturing picks up, other Chinese developments are key. Both its currency and wages are set to climb, a sign that Beijing may start exporting inflation. During the Great Moderation, a time of low consumer price inflation, China’s undervalued yuan and cheap labour did the opposite.

Third, the great failure of the Great Moderation should have taught the world that consumer prices aren’t the end-all and be-all of inflation. Money can find its way into assets such as property or commodities or even emerging market stocks. Considering central banks have been on overdrive since 2008, the extra money they’re printing is bound to chase something.

And, now especially, central banks plan to stay in overdrive. That’s why everyone isn’t haunted by the deflation spectre. Billionaire investor Warren Buffett is betting on inflation while hedge fund titan George Soros is busy buying gold, the classic hedge against inflation. Come September, the second anniversary of Lehman’s collapse, world markets may have to start fearing a price rise.

India is not isolated from this. Just as the panic of 2008 was felt here, as well as the relief of 2009, this autumn could again disprove notions of decoupling.

Deflation or inflation: which is more likely? Tell us at views@livemint.com