Forget inflation, deflation theories: It's time to assess impact of early withdrawal of monsoon on prices

Debate has now been triggered on the issue of deflation in the country and the impact of the same. Deflation is a situation where we witness, on a sustained basis, a fall in prices. Based on rudimentary principles of economics, when demand keeps falling short of supply, prices tend to move downwards and the change in prices becomes negative. This is deflation and normally associated with a fall in employment as labour becomes redundant and companies have to perforce economize here. How does it work in our case? If we look at the WPI inflation index, for the last 9 months the year-on-year change has been negative. The same holds for the fuel component, while primary articles have witnessed negative changes in last 3 months with food inflation turning negative in July. Manufactured goods too have been in the negative zone for 5 months. Therefore, on the face of it, inflation going by the wholesale prices (which can be considered to be a producer’s price index) has entered the negative territory. Even in case we look at the changes in these indices on a month-on-month basis, a similar picture emerges even though it may not be that stark. [caption id=“attachment_2421346” align=“alignleft” width=“380”] Reuters[/caption] These negative changes imply that as far as industry is concerned in particular, there is a loss of pricing power as these prices are what companies receive and they have been at a disadvantage. But if prices of manufactured goods are coming down, which is what the index says, then prices should be falling in the market, which is not happening. Prices of motor cars, toothpaste, consumer goods, shaving cream etc. have definitely not come down which contradicts what the index shows. The reason for this is that the benefits are not accruing to the consumer. Therefore none of the major components of the CPI display a negative tendency. An explanation here is that a decline in price is due to the fall in global commodity prices of oil, metals and other raw materials which has compressed margins of companies. However, as a final producer and seller of a good, companies have not lowered their prices which lead to this apparent paradox. While some industries have lowered prices to maintain sales and push sales, most others have preferred to retain status quo. The rest is more of a statistical mirage. Also while there has been limited increase in employment in this sector with the burden falling on outsourced labour, there have been no pervasive instances of job losses. This is probably one reason why final prices have not come down as costs are being absorbed which is getting reflected in lower profits. Interestingly within the group of manufactured goods, 6 of the 12 major categories witnessed negative inflation while 6 others had positive inflation. Metals and chemicals were in the group of negative inflation while transport equipment, machinery and non-metallic products continued to have positive inflation. In fact, even if we look at the CPI index, we normally talk of a base effect of last year witnessing high levels of prices which will make the current year numbers look more encouraging. This is one reason why the RBI has pointed out that it would wait and see how inflation behaves after September as the August index last year was very high which will impart a downward bias to the inflation number this year. To give a simple example which we can relate to, in 2013-14 onion prices increased from Rs 15-20 a kg to Rs 80-100 a kg. Subsequently it has come down to Rs 40 and then Rs 20-25. The CPI index has hence shown a sharp decline in price. But whenever such prices come down, they settle at a new base level which is higher than they were when they went up sharply. The situation we have today hence gives opposite signals. The CEA is worried about deflation as companies will have no incentive to produce if prices are falling. While it is true that their costs have also declined, the fact that at the end of the day, profits are declining indicates that they are net losers. The RBI on the other hand is looking at the consumer side and the index here shows that there are still threats of inflation as the index consists of a different set of goods where prices are vulnerable to external factors. With weight of close to 50%, food items have a weight of just 14% in the WPI which explains a large part of the difference in the indices. Further, the CPI index has other components like clothing, housing, travel, transport, etc. which includes the service sector to a large extent which is missing in the WPI. These prices rarely come down – taxi fares or bus tickets never come cheaper and only move in the upward direction. Similar, rent paid on housing rarely comes down and remains unchanged for most of the time if not increasing. Therefore, the picture emerging is that when we look at inflation there are two sides to it. The producers’ prices, which is broadly covered by the WPI does indicate that there is a problem. The CPI, which includes food and a number of services, is showing a different tendency which in turn will ask for a different response from the RBI. They are at odds and need different approaches. While the RBI is addressing the CPI inflation related problems, the WPI concerns are hard to monitor as the factor that is guiding the prices is external over which we have little control. Given that the IMD has more or less confirmed that the monsoon will be deficient to the extent of at least 12% (as was last year), while sowing has been on schedule, the early withdrawal and its impact on prices has yet to be assessed. The CPI number can show upward tendencies once the base effect wears off, while the WPI may still go downwards given that China could be slipping a bit faster than was expected which will impact industrial prices further. The dichotomy could become even more glaring in the coming months. The author is chief economist, CARE Ratings. Views are personal