2008 onwards : It’s a complicated world

There are those who insist that the primary global concern currently is deflation, not inflation. Yet, this stems from a focus on the American economy, particularly in the near term of the next two quarters. The spotlight on the US is important; the global financial meltdown that originated there has had its repercussions all over, affecting different countries with varying severity. In July 2008, when crude oil had peaked at nearly $150 a barrel, Fed Chairman Ben Bernanke noted that the inflation outlook was ‘unusually uncertain’. Thereafter, crude oil and commodity prices crashed as the global economy tanked, with the distress in the financial sector in the US spreading like wildfire across the world. With the US officially in recession, sustained deflation is considered a threat this year. According to James Bullard of St. Louis Federal Reserve Bank, zero or negative inflation could continue through 2009 - "For this reason I think we face some risk -- at this point oonly a risk -- of sustained deflation," he said . On the other hand, leading macroeconomist Axel Leijonhufvud’s   analysis of the crisis looks at the wider picture. Given that the problem lies in the state of balance sheets – the banking system is near insolvency, firms are stuck with short-term debt that cannot be rolled over and US households are heavily indebted - standard solutions like fiscal stimulus will not be effective as long as the financial system is de-leveraging. Governments should work at recapitalising the financial system and should spend enough to offset falling incomes. If the government programmes fail to counter the damage, there will be a long period of deflation. However, if the programmes do succeed, severe inflationary pressures can surface quickly. The global dimension adds to the problems in the US; when foreign creditors begin to falter from holding dollars, inflation will be hard to contain as the dollar will dive downward. To sum, if the issues that have surfaced in the financial sector are to be resolved, inflationary pressures will surface sooner or later in the US economy, while deflation is on the cards in the short-term. 

Moving on to Europe, according to Robert Ophele of Deutsche Bank, the outlook is for higher inflation levels by the year end. He notes that once the shock of the fall in energy and food prices – which may lead to temporarily negative inflation rates in mid-2009 – has been absorbed, the year-on-year change in prices should become positive again in the autumn, at which time the base effects with respect to energy prices will have disappeared and the measures taken by central banks and governments will have borne fruit. According to current projections, inflation is expected to increase again in Q3 and reach an annual rate of over 1.5% at the end of 2009 , with projections for 2010 at 1.8%.
 
His arguments are bolstered by Sylvester Eijffinger  of Erasmus University, Rotterdam, who feels that deflation fears are exaggerated for Europe. He cites the ECB and OECD who expect falling rates of inflation, but not deflation. One of the main reasons is the nominal and real wage rigidity in European labour markets that make downward revision extremely difficult. Eijffinger uses data till November 2008 to show that, except for Japan, no country faces deflation risk in the one and two-year horizon. He therefore cautions policy makers and all economic agents to wait and not push for rapid cuts in interest rates, especially since excessively low rates were an important factor in creating the sub-prime crisis in the US. To sum, in the medium term, the risk of excessive inflation is much higher than the risk of deflation.

So what is the outlook for India?

While in most countries inflation is measured by consumer prices, the barometer of macro-economy in India is the Wholesale Price Index , which despite all its limitations , is the conventional indicator for inflation.

While headline inflation measured by the WPI begun its sharp rise in October 2007, it broke into double digits in June 2008 with the hike in administered fuel prices. Throughout the up-trend from 2007, there were inflationary pressures from primary articles especially minerals and metals. The fall in crude prices gave the government enough leeway to cut prices, bringing the WPI inflation back into single digit levels in October. Looking at month-on-month changes, again the main factor of fuel prices shows up – in a spike in June 2008 and drops over Q3 of 2008-09. The chart which shows annualised monthly inflation also reveals that there is generally a seasonal drop in the prices during winter and a rise in summer. However, since inflation in India is presented on a year-to-year basis, without any seasonal adjustments, the headline inflation is the number that guides expectations.

What do the forecasts say?

With all the uncertainty and volatility over the last year, forecasts have been changing quite drastically. Table 1 compares the forecasts for inflation made in two consecutive quarterly surveys conducted by the RBI - inflation forecasts have come down drastically over the last quarter, currently there are some estimates for negative inflation in Q1 and Q2 of 2009-10. However, in January 2009, the expectation was still for a rebound in the inflation rate by Q3. The reason for this is quite clear, as explained in the European context earlier, there will be a temporary phase of negative inflation, coinciding with the peak periods of high inflation in the previous year, once the base effect runs out, there will be an up-trend in the rate of inflation.

Table 1: WPI Forecasts RBI Survey of Professional Forecasters January 2009
(Figures in brackets from September 2008)

                       Median              Max                  Min
Q4 2008-09       4.8 (9.7)          6.0 (11.8)         2.1(7.5)
Q1 2009-10      2.4 (6.7)           3.5 (10.5)        -1.5 (4.5)
Q2 2009-10      0.1 (5.5)           3.2 (6.2)          -2.0 (3.0)
Q3 2009-10      3.0                   4.4                   1.0

In February, Barclay’s Capital issued a forecast : “With growth slowing significantly, commodity prices falling and more fuel price cuts likely on the way, deflation may emerge in May and persist until at least October.”  WPI deflation may peak at –4% in June, said the statement. This trend is in line with the above forecasts – a temporary phase of negative headline inflation, to be succeeded by rising levels of inflation.

The next question that then arises is – is there a possibility of inflation being higher than visualised currently in the year ahead? Unfortunately, there are enough of risks waiting out there to push inflation to levels higher than that expected now. To begin with, in common with the rest of the world battling growth concerns, the Indian policy makers have cut interest rates, unleashed liquidity and brought out three stimulus packages in 2008-09. Add to this the farm loan waiver, high Minimum Support Prices given by the government, Pay Commission salary hikes and an election due in April-May which will see ample funds moving through the unorganised sector of the economy, there is sufficient reason to anticipate inflationary pressures in the system. The current year’s fiscal deficit moved from a budgeted 2.5% of GDP to touch 6.0% by the year end, and is to be followed in 2009-10 by a similar level of 5.5% of GDP. Such high deficits go hand in hand with high inflation rates, indeed this was one of the reasons for curtailing them in the first place. Moreover, the depreciation in the rupee, with low capital inflows, that is the absence of the main factor in the rupee strength in recent years, is another cause for concern on the inflation front.

Even the US has not given up on the possibility of higher inflation. In fact, in February, Bernanke  ‘offered assurances that the Fed was not taking too much risk and that, once the economy turned around, it could nip in the bud any dangerous outbreak in inflation caused by the deluge of money.’ But as Wharton’s Allen warned,  "It may get out of control. I don't think we've had nearly enough discussion of that in the public sphere." There are other uncertainties out there in the global system; the short spike in the Dry Baltic Index of shipping rates in February  did not signal a trend, but was a fleeting reminder to the possibility of a sharp up-tick in prices, when global growth outlook improves.

In India, one of the most significant risks is the monsoon factor. It goes without saying that a drought will not only drastically affect growth but will raise inflationary pressures. Further, despite normal monsoons in the past five years, climate change has resulted in changes in rainfall distribution and timing. e.g. higher than normal temperatures and dry weather in the early part of the year has affected wheat output. In fact, in a system flush with liquidity and supply constraints, the possibility of a bubble in agricultural commodities cannot be ruled out.

Conclusion

Given the nature of this crisis where the rot in the financial sector has to be cleaned up sufficiently to allow smooth flow of production and trade, it is difficult to see a clear trend in the years ahead. What is more likely, as Thomas Mayer  of the Deutsche Bank rightly noted, “Until the restructuring of the global economy is complete, growth may well seesaw, with recessions followed by short-term rebounds on the back of fiscal policy stimuli. We may see a multiple-dip recession stretching over several years until the new driver of the next global expansion is finally in place. We are likely to avoid deflation, but a deep and potentially long recession seems inevitable. Thereafter, the overindebted consumers in the industrial world will probably have to settle for lower growth and higher inflation than they experienced in the last two decades. The main drivers of the new self-sustaining global expansion following the present adjustment crisis will be the middle classes in the emerging-market countries.” In this new world, where developing countries are poised to play a larger role, it would be wise to be prepared for any eventuality, rather than dismiss arguments like impeding inflation that may seem implausible and inconvenient.

Appendix:

Two stylised facts on inflation trends:
a) This decade has been marked by significantly lower inflation than the preceding decade, what has been termed the period of Great Moderation
b) India has had higher rates of inflation than the developed world.

Average consumer price
inflation % p.a                      1990-2007              1990-99               2000-07
Japan                                     0.5                         1.2                     -0.3
Singapore                               1.5                         1.9                      1.0
France                                   1.9                         1.9                       1.9
Taiwan Province of China          2.0                         2.9                       0.9
Germany                                2.1                         2.4                       1.7
Canada                                  2.2                         2.2                       2.3
United Kingdom                      2.5                         3.3                       1.6
United States                         2.9                         3.0                       2.8
Malaysia                                 2.9                         3.7                       2.0
Italy                                      3.3                         4.1                        2.4
Hong Kong SAR                     3.5                          6.9                       -0.8
Korea                                   4.5                          5.7                        3.0
China                                   5.1                          7.8                        1.7
India                                    7.3                          9.5                        4.6
Philippines                            7.6                           9.7                       5.0
Indonesia                           11.9                          14.4                      8.7
Russia                              111.3                         222.2                    14.2
Brazil                               478.1                         854.8                      7.3

Source: IMF Economic Outlook Database October 2008
Note: Brazil and Russia went through hyperinflation in the 90s

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Source: Monthly Economic Digest publlished by Maharashtra Economic Development Council