Deflation fears prompt analysts to urge for rate cuts

According to government data released Thursday, the wholesale price index (WPI), India's most widely watched inflation measure, sank to 0.44 percent for the week ended 7 March, 2009, as compared to 2.43 percent for the previous week and 7.78 percent during the corresponding week of the previous year.

The inflation rate had touched a 13-year high of 12.91 percent last August due to global slump and slowdown in domestic demand.

A close look at the latest data reveals that decrease in prices of primary articles and fuel, power, light and lubricants resulted in the sharp fall in inflation rate.

According to a government statement released by the Finance Ministry, this is the steepest drop since November 2008.

"In the last 30 years, there is no record of inflation falling this low since 1977-78," the statement said.

The sharp fall in inflation rate has triggered renewed fears of deflation, prompting market analysts to claim that the latest inflation data would open the way for the Reserve Bank of India (RBI) to cut interest rates further to lower the cost of credit for the corporate sector and push demand.

Since September, the RBI shifted its focus from arresting high inflation to boosting consumer demands and corporate investments and has aggressively slashed key short-term interest rates five times to ease liquidity crunch in the system and boost growth.

In the beginning of March, the central bank slashed its repo and reverse repo rates by 50 basis points (bps) each, effectively bringing down the key interest rates to 5 percent and 3.5 percent respectively. Earlier, the cash reserve requirement (cash reserve ratio or CRR or the proportion of deposits banks need to keep with the central bank) was also brought down by 50 bps to 5 percent. But with the consumer price index (CPI) or retail inflation still at an elevated level of over 9 percent in annual terms and dip in industrial production and contraction in exports as well as imports threatening to bring down India's economic growth rate to 7.1 percent or less in the current fiscal year, a sharp drop from 9 percent or more recorded in previous three years, analysts are hoping for one more round of rate cuts before the nation prepares for general elections in April-May.

Deflation is when the inflation rate falls below zero percent, resulting in an increase in the real value of money a negative inflation rate. Inflation reduces real value of money while deflation increases the real value of money.

According to the analysts, a decline of one percent in the index for primary articles contributed to the low inflation rate. However, the prices of many essential food items, including cereals, grains and pulses, remained high compared with the prices recorded in the corresponding period last year.

Analysts said a reduction in the prices of essential commodities might not happen, as a fall in the inflation rate only showed a fall in the rate of rise in the prices and it might not affect the actual prices.

"The fall in the inflation rate does not carry comfort for the common man," said D.K. Joshi, principal economist at credit ratings agency CRISIL, as the year-on-year inflation rates for various items such as sugar, cereals and pulses are in double digits or near 10 percent.

"Falling inflation rates doesn't mean falling of prices, it only implies the rate at which the prices of goods are growing is low," Joshi said.

"Energy and manufacturing product prices have come down but the food prices are still rising," Joshi said. Food prices have a roughly 70 percent weight in the consumer price indices.

However, Joshi said if the CPI is considered, the real interest rate - the difference between the actual interest rate and inflation rate - has not increased that much.

"The expected inflation rate is important for calculating the real interest rate. Inflation may turn negative at 2-3 percent soon but it would be temporary. We can expect to see inflation close to zero by March-end and it could turn negative by May-June this year. It is then when we will see actual fall in prices of goods. I see inflation at 4 to 5 percent in one year and beyond," he said.

According to Shubhada Rao, chief economist at Munbai-based Yes Bank, "The dramatic decline in this week's inflation number is essentially a reflection of a very strong base effect."

"This, combined with weaker demand conditions imply a strong likelihood of inflation going into negative territory in the next couple of weeks," Rao said.

"This phase is likely to continue through next two quarters. The dilemma will continue for policy makers as the CPI is still over 9 percent," she said.

Close on the heels of the International Monetary Fund (IMF) urging India that it should rely more on monetary policy to support the economy because it already has a ballooning fiscal deficit and has exhausted options such as additional spending and tax sops, the analysts have also urged the central bank to boost credit flow.

"There has been a very sharp decline in primary food products. It augurs well because it will close the gap between CPI and WPI. We are looking at deflation by the last week of March. It will have a stabilizing impact on bond yields in the days to come," said Abheek Barua, the chief economist at HDFC Bank.

"It also gives the central bank that much more headroom to keep cutting rates," he said, adding that the RBI should take a cue from the latest inflation data and take steps to relax benchmark interest rates and infuse funds into the market.

However, according to Indranil Pan, economist with Kotak Bank, low inflation is unlikely to affect the yield or return on government securities, since the amount of borrowing affects the return more than inflation or key interest rates set by the RBI.

"The yield is unlikely to come down because there is a supply-side pressure in the market," Pan said, referring to the fact that the government will borrow more to finance its widening fiscal deficit.

CPI inflation is unlikely to fall below 5 to 5.5 percent in the next four months, he said, adding that the market is not expecting any rate cut by RBI in the remaining days of the current fiscal.

"The higher base effect along with low demand in the economy is expected to keep inflation in negative territory for five to six months. Inflation will turn negative starting from April and will remain so until the end of 2009. We expect the RBI to ease liquidity to support growth," said Tushar Poddar, economist at Goldman Sachs.

"We expect negative readings to start in late March or early April, lasting for around two quarters (six months)," said Sonal Varma, economist at Nomura Financial.

According to Varma, cuts in state-set fuel prices, falling global commodity prices, and government policy measures such as cuts in duties have contributed to the sharp fall in wholesale price inflation.

"A combination of falling primary and fuel prices, and a high base from last year have led to the sharp fall in inflation," Varma said.

However, the effect has been less pronounced on consumer price inflation, he noted.

"CPI inflation remains firm, but given the sharp easing in input cost pressures, we expect CPI inflation to moderate, even though with a lag," he said.

"From the policy perspective, we continue to expect the RBI to cut both the repo and reverse repo rates by 100 bps by mid-2009," he added.

"This (fall in inflation) has provided more headroom to the RBI for further strong monetary measure to revive demand and support the economy," said Yashika Singh, research head at Dun & Bradstreet, India.

"Supported by the coming deflationary patch in the WPI as well as continued weakness in incremental data, we expect to see further monetary easing of 100 bps in the coming months. We expect continued (monetary) policy action, including unconventional measures, to stem the deceleration in growth," said Citi analyst Rohini Malkani in a research note.

"The numbers are lower than expected but certainly in line with the trend that we had expected," said Atsi Sheth chief economist at Mumbai-based Reliance Equities.

"The trajectory of the decline will be a little more accelerated, but our basic view that in the next three months we will see lower inflation, largely because of fuels and metals prices being far lower than last year, still remains the case," Sheth said.

"In terms of policy response, also our expectation remains the same we think the RBI will cut by 100 bps the CRR, repo and reverse repo, with the first cut probably coming around its meeting in April and the second one some time in May or June," the economist added.

"This is the lowest set of numbers in the current WPI series (that has 1993-94 as the base year for prices) and there will definitely be a technical deflation, which will accelerate the probability of a rate cut," said Sujan Hajra, the chief economist at Anand Rathi Securities.

The drop in the inflation rate may also give the central more room to cut rates should the economy weaken more, especially as the government's finances continue to deteriorate, said Manoranjan Sharma, chief economist at Canara Bank.

"We are looking for one more 50 bps reduction in rates before the Indian general elections take place," Sharma said.

Indranil Sengupta, chief economist at DSP Merrill Lynch warns that the country would feel the impact of deflation within a few months due to the base impact.

According to Sengupta, though inflation is not going to be a worry for the next five to six months, yet, it is disconcerting that money supply is low. "If (economic) growth does come down to around 5 percent or so, then clearly going forward at some stage we will have to worry about inflation maybe eight months to one year down the line. So, the RBI will have to balance factors," he said.

Sengupta said further monetary easing is expected and sees revival in demand due to decrease in lending rates. "We are likely to see a 100 bps lending rate cut in the slack period between April and September," he said.

Sengupta also sees lower deposit rates in the near future. "We are all concentrating on what the central bank is doing. What you have to really see is what the cost of funds is like for banks, and that requires lower deposit rates," he said.

Saugata Bhattacharya, economist at Axis Bank, also agrees that the central bank should move quickly to cut benchmark interest rates soon but disagrees that India is on the brink of deflation.

Characterizing the sharp deceleration in inflation rate as disinflation rather than deflation, Bhattacharya said, "Deflation implies some systemic weakening of demand over a sustained period of time and so on. This is mostly a technical statistical quirk in the system."

Both deflation and disinflation are negative inflation but distinct in character. While deflation is a negative inflation that results from a sustained reduction in prices and occurs during a recession or a severe economic slowdown, disinflation is negative inflation but not necessarily because of a fall in prices of goods. It happens due to a statistical inevitability called a "base effect."