'Deflation' round the corner: Is it a time to rejoice?

Indian Economy is heading towards a serious 'Deflation' soon, and this is a matter of concern for the Economists and Policy makers. Inflation rate (measured by WPI in India) has fallen to its 30 year low of 0.44% as on 7th March 2009, as compared to 2.43% a week earlier. However, the paradox remains: Prices of food items included in WPI have risen 7.34%. The lower rate of WPI inflation is due to sharp reduction in price of industrial goods and fuel, and also the low base effect of WPI calculated this time of last year. Normally a fall in prices is welcomed by consumers, so is it a time to celebrate?

To answer this question we need to understand the concept of "Deflation'. Deflation is defined as a sustained fall in prices that occurs when the inflation rate falls below zero percent. As the prices of goods start falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity contributing to the 'deflationary spiral', which is detrimental to the growth of the economy. This is a more worrisome situation than tackling inflation. The ill effects of deflation can be summarised as:

• Companies are forced to sell products at distress prices reducing their profitability, leading to production cuts and cost cutting.
• The above step leads to large scale lay offs or pay cuts, leading to defaults in debt/ loan repayments.
• Equity markets tend to move down as the performance of companies gets effected. Investment in high debt ridden companies can be highly detrimental in deflationary conditions.
• If deflation is allowed to persist it can create a severe 'Liquidity trap'. This is what most central banks have been trying to avoid by pumping more liquidity into the system.

What are the implications of Deflationary trends on Indian economy? The silver lining is that although the demand has softened, domestic consumption is fairly robust. The fall in global commodity prices is good for the Indian economy in the long run. The Govt. can help tackle the deflation by providing demand stimulus by further lowering interest rates. It is high time that we lowered administered interest rates (It may not be a bad idea to lower small savings rates and Bank savings deposit rates marginally).