Graphic: Ahmed Raza Khan/Mint
Graphic: Ahmed Raza Khan/Mint

Is India close to deflation?

The 'D' scare comes across as disguised pressure to get the Reserve Bank of India to ease rates aggressively

Following the release of April-June gross domestic product (GDP) numbers last week, chief economic adviser Arvind Subramanian reportedly said: “The one real challenge that looms ahead for India’s economy appears not to be price inflation but possibly price deflation." He has also been quoted as saying: “India is in or close to deflation territory." How relevant is this deflation, or is it another way of putting pressure on the Reserve Bank of India (RBI) to cut interest rates aggressively?

The use of the ‘D’ word is intriguing because Subramanian also reiterated the government’s GDP growth forecast of 8% growth in 2015-16. This follows a weaker-than-expected outcome of 7% in the June quarter. He also maintained the government’s Consumer Price Index (CPI) inflation forecast of 5-5.5%.

Not only is the inflation forecast unchanged from the one made earlier in the year (before the recent slump in commodity prices), it is also higher than July’s inflation of 3.8% though the direction isn’t surprising because of the base effect.

Government officials and politicians conveniently focus on input prices, which have indeed corrected sharply, thanks to global factors. However, RBI correctly continues to stick to CPI inflation, which it agreed with the government to be the legally binding yardstick for the recently adopted monetary framework. The gap between input price captured in Wholesale Price Index (WPI) inflation, which is also affected by inflation in tradables, and CPI inflation has been widening.

The gap partly reflects the bigger and faster decline in WPI inflation, thanks to the slump in global commodity prices. However, the pace of the pass-through to retail inflation has been slow and the magnitude less than desired.

Subramanian’s assessment follows RBI governor Raghuram Rajan’s concern in a speech in late August that “… while CPI inflation has moderated, inflation expectations amongst the public are still high, creating a gap between the real rates that savers expect and the rates corporations think they pay".

Unfortunately, New Delhi and Mumbai appear to have differences on the outlook for inflation and the relevant inflation yardstick. RBI uses the new framework as its dharma, as it should. However, soundbites by government officials and politicians give the impression of being less enamoured with the monetary framework it is party to.

The use of the word deflation when aggregate demand—in the government’s own assessment—is expected to recover, is technically incorrect. Deflation is more than just a case of temporary negative inflation because of, say, a plunge in commodity prices, the impact of which will be a one-off and spread over several months. Deflation captures a significant shift in consumer behaviour, including postponement of spending in anticipation of lower prices. That is hardly the case in India. In fact, the Indian consumer will perk up following the mini-boost from the forthcoming announcement of the Seventh Pay Commission.

There is no doubt that the collapse in international commodity prices helps Rajan in his goal of delivering of low and stable inflation. This remains a work in progress, but will facilitate at least one more rate cut, perhaps even two rate cuts. These are hardly aggressive by any strength of imagination.

However, the government remains conveniently silent in explaining why inflation expectations remain elevated and why retail inflation is so much higher than input price inflation. This is partly because of India’s chronic sector-specific imbalances—for example, health and education— as demand for these, given the favourable demographics of the aspirational voter, outpaces their supply.

To be sure, India’s inflation fight cannot be won just by lower international commodity prices. Domestic supply-side structural changes, where the government can have the greatest impact and which are critical for low and sustained retail inflation, remain painfully slow and uneven.

Rajan’s success in delivering the 4% CPI inflation agreed to with the government by early 2018 remains ambitious. It will have to be achieved even as economic growth accelerates and corporate pricing power returns in what remains a supply-constrained economy. There appears to be a gap between the path-breaking goal of what RBI is attempting to achieve over the medium term and what businesses and politicians want it to do now.

Unfortunately, the gains from low inflation and low volatility in inflation continue to be underestimated. This is ironic given that India just recently paid a heavy price for the unsustainably high retail inflation. The general behaviour among businessmen and politicians seems to be that inflation is dead and gone forever. What is overlooked is that the central bank is positioning for CPI inflation to decline to 4% on a sustained basis. This in turn will facilitate lower interest rates for longer.

Perhaps the government should explain why, if it is so worried about deflation, it hasn’t revised its own CPI inflation forecast since the recent slump in commodity prices was unexpected. More importantly, should one be scaremongering about deflation in India when the government itself forecasts retail inflation at 5-5.5%? That will position India as possibly having the highest, or one of the highest, inflation rates among its Asian peers.

Government comments about deflation without little regard for CPI inflation appear to undermine the sanctity of the CPI-centred monetary framework. It isn’t clear if it is having second thoughts about the discipline enforced by it. Frankly, the monetary framework, which is still in its infancy, cannot be only a fair weather friend for the government.

Rajeev Malik is senior economist at CLSA, Singapore. These are his personal views.

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