No hasty conclusions, please

No hasty conclusions, please
The Economic Times, March 21, 2009, Page 10

Deflation Is More A Statistical Construct

WITH the wholesale price index (WPI) for the week ended March 7 falling to 0.44%, prima facie the spectre of deflation seems to have replaced that of inflation. Note the words, prima facie. In reality, as government spokesmen have been quick to point out, deflation, defined as a sustained decrease in the general price of goods and services, is highly unlikely in the Indian context where supply, rather than demand, is the constraint. The sharp fall in the latest WPI number is more the consequence of the high base effect — inflation in the corresponding period last year was a high 7.78% — than a sustained, absolute decline in prices. Going forward, we are likely to see a continued fall in the inflation rate, or disinflation, thanks to the sustained increase in the comparable figure till August last year when inflation peaked at close to 13%. It is quite possible the inflation rate, as measured by the WPI, may even dip below zero for some weeks. But it would be wrong to read that as the onset of deflation. Indeed, as the consumer price index (CPI) shows, the inflation rate in consumer prices, which is what the man-on-the-street experiences, is still in double digits (10.45% for January).

So perish the thought of deflation. It is not just a question of semantics. A correct reading of the numbers is critical to ensuring the right policy response. Just as high inflation reduces the real value of money and has negative welfare implications apart from affecting investment decisions adversely, deflation, though it might seem to increase the real value of money, is just as avoidable from the larger economy perspective. Most economists agree that between inflation and deflation the latter is the worse evil. The effects of modest, long-term inflation are less damaging than deflation. This is because when prices are falling, consumers tend to delay their purchases in the hope they will be able to buy later at still lower prices. This reduces overall demand and economic activity. Deflation also raises real wages at a time when falling demand is gnawing at companies’ profits, resulting in layoffs and rising unemployment.