BackOpinion | A fiscal boost could act like a deflation vaccine
If a demand slump were to send general prices on a downtrend, it would worsen the health of our economy. It’s a risk that New Delhi could crush with timely and well-aimed spending
PremiumWhether deflation is a threat to our economy and if a spurt of fiscal outgoes could rescue prices are questions best addressed right away. Indian wholesale inflation was reported to have fallen below zero in May. In itself, this is no cause for alarm. This index does not reflect the rupee’s general purchasing power, and has gone negative in the past—as in 2015, last—without turning worrisome. What differs today is the cloud cast on price forecasts by corona uncertainty. Difficulties in data collection have made retail inflation hard to estimate, and the central bank, which is committed to keeping this number in a band of 2-6% over the previous year, has held back its projections for good reason. Our economy was hit by both supply and demand shocks. If an unlocked India were to suddenly see production outstrip consumption, we would have too much on sale for too few buyers. This could send prices sliding at the retail level, too. While people at large may welcome each rupee being able to buy more, sustained deflation would make it harder for us to haul the economy out of its slump.
Sparse data on prices does not allow a proper analysis of that risk, unfortunately. For signs of structural trouble, analysts look at “core inflation" stripped of volatile items like fuel and food. Wholesale prices of the former fell in May, but not of the latter. As retail fuel rates can be kept under control, generalized deflation does not seem imminent. Yet, it could set in at some stage if demand for other stuff weakens even as supply strengthens. The current perplexity is that these forces could work the other way around as well, with insufficient products being churned out to satisfy needs. Which way prices go, up or down, could vary from specific market to market. Either way, prudence would require us to keep a close track of price trends.
What policymakers must watch out for is a deflationary scenario that threatens the stability of our rupee’s domestic value. The credit crisis it could cause is also why the central bank has a 2% lower limit for inflation. A gain in the currency’s internal value would increase the real burden of debt on all borrowers, making it harder for them to pay back and raising the likelihood of defaults. It would also deter businesses and households from taking fresh loans, weakening credit as a device to spur economic activity. Lenders eager to lend might be saddled with idle cash. Of course, interest rates would also decline as our monetary policy is eased in line with falling inflation. But, so long as bank depositors are to be paid anything at all, rates cannot be reduced beyond a point. Should the central bank’s policy rate hit rock bottom amid deflation, its principal stimulus tool would turn ineffective. Nominal rates being low would mean little, after all, if deflation were to push real rates high. In the extreme—if unlikely—event of a deflationary spiral, a wave of deferred spending could depress demand even more, as would-be spenders sit on their money and wait for prices to fall further. The textbook response to such an economic seizure is for the government to play spender-in-chief. In fact, the very existence of such a threat should prompt the Centre to keep a cash pump handy. If a fiscal boost is aimed and timed well, it need not cost too much either. Injecting money where it is most effective could help keep inflation positive.
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