Deflation is ’a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. The opposite of inflation’.

Now a major question, which arises is that falling prices are good for economy as it would increase the purchasing power of consumers and boost demand. But this is not true all the time. When falling prices are accompanied by fall in wages, unemployment and asset prices, it’s a dangerous sign for an economy. For example, in the 1930s and more recently in Japan, deflation reflected economic collapse and rising unemployment made worse by the combination of high debt levels and falling asset prices (bad deflation).

In the current scenario of global meltdown, with high households debt levels in key countries and falling asset prices, spell of bad deflation is bound to be witnessed. The past few months have witnessed aggressive decline in inflation and in US, it has fallen from a peak of 5.6 per cent over the year to July to just 1.1 per cent over the year to November and is still falling.

A similar trend is visible in the emerging countries also. In China, inflation has fallen from a peak of 8.5 per cent in April to 2.4 per cent in November, whereas in India inflation climbed down to 6.6 per cent in November from a peak of 13 per cent in July. These deflation worries are also spilling over Europe and Japan.

The fundamental drivers of this deflationary trend are:

Hunch in commodity prices is cutting inflation via lower petrol prices and via lower raw material prices. Prices of these commodities came down from historical highs that were mainly attributed to strong demand from emerging economies like China and India. Suddenly prices plummeted. Not only oil recorded a highest fall but metals like copper recorded a fall of about USD 8900 a metric tonne in June to USD 3800 and aluminum from USD 3000 a tonne to USD 1900. In theory, lower commodity prices could be a boon, if propensity to spend among consuming nations is more than the producing nations. In such a scenario lower prices would lead to global recovery. But according to many economists, lower commodity prices may proclaim a broader deflation.

This cycle would work in the following way:

a) Debt: As prices fell and old debt stay fixed, companies would be facing difficult times in repaying these debts; bankruptcies and unemployment will increase; banks would suffer more loan losses; if wages fell then same would be the case with household debts.

b) Deferred spending: If people believe that prices will be lower next month, they may wait to buy and if too many shoppers wait, the economy would coil downwards.

Secondly, underlying inflation pressures will fall in normal lagged response to the global recession. This is because the recession will lead to global spare capacity and this leads to discounting putting downward pressure on prices. Excess capacity in Chinese factories will also see China return to its position of exporting deflation to the rest of the world in order to help keep its exports up.

The US recessions of the mid-1970s, early 1980s and early 1990s were associated with falls in US inflation, excluding food and energy of six, nine and 2.5 percentage points respectively. A 2.5 percentage point fall in US core inflation from its recent peak would take it to zero.

Is India facing a risk of deflation?

If we look at the current inflation numbers for India, it stands at 6.84 per cent. This fall in prices is led by fall in crude oil, commodities and prices. So does this imply that India also has risk of deflation?

According to many analyst and economists, possibilities of deflation in India are slight.

Reasons factored out for this are:

Firstly, India has taken various policy measures to buffer the economy. Repo rate, SLR and CRR have already been slashed. CRR can be brought down to about three per cent (RBI’s medium term goal). All these measures in turn would infuse liquidity into the economy. It is estimated that these measures would result in additional release of rupees two lakh eighty-eight thousand crore into the system.

Secondly, fiscal dole outs such as Sixth Pay Commission award, farm loan wavier, income tax exemptions and employment guarantee scheme will put Rs 1,20,000 crore (2.5 per cent of GDP) into the system in turn boosting consumption demand.

Thirdly, the current declining inflation is just a one time number, with no trend and could be revised upwards. Private consumptions still forms around 60 per cent of GDP and is expected to be steady, preventing prices from falling due to lack of demand.

Lastly, if we look at the Indian banking system, it is quite safe and sound with capital adequacy ratio of most banks at 12 per cent against the mandatory nine per cent. The money multiplier will have to rise to meet growing demand for funds, subject to additional capital with banks. While Non Profit Assets (NPAs) will rise as the economy slows, net NPAs at one per cent of total assets provide comfort.

More importantly, housing/realty is less than 14 per cent of the total loans and most of these loans are well collaterised. Importantly, realty prices have not crashed, preventing mass delinquencies and thus minimising the deflationary impact.

However, everything is unpredictable in the present scenario. In the current phase, we are facing a crisis, which only few could have predicted. Pre-crisis global economies were enjoying what was termed as great-moderation – a phase of high growth and low inflation. And the present picture of advance economies is of recession plus deflation.

Therefore, Indian policy makers need to remain alert, to protect economy from any adverse shocks.