Paradox Of Low Inflation

Economics is an interesting discipline because of its uniqueness as “human science”. Humans defined a perfect world and then perfect events with perfect response to them. To err is human and quite honestly, economists have erred more than just once. Owing to the absence of a universal force, economics provides a wonderful scope to tweak our self-created models.

Initial economic models worked without a framework for inflation, for it was not so much of a concern. Then they were modified when the force of inflation became relevant, mostly in a negative context, thereby being bestowed with the notorious title of “necessary evil” or the force to “confiscate, secretly and unobserved, an important part of wealth of the citizens”. So Governments and Central Banks across the globe tried to keep it on a leash. Later it dawned upon us that too low inflation is detrimental to economy’s growth so we started targeting an optimal rate of inflation.

Inflation and Sentiment – Is there a Consistency?

Around 2010, there was huge hue and cry around high inflation. And high inflation turned out to be a leading cause behind dethroning the previous government in the 2014 elections. Then, our present government came into power and beautifully worked on curbing inflation.

They (of course) had a support of several factors such as – the crude prices by their side and a paradox of plenty played on the agriculture front, thereby controlling the food prices. Low procurement by the Government kept grain prices well under control. Food and fuel alone contribute about 51% of CPI basket, so with these two controlled, headline inflation has been hovering between 2-2.5% in the past five months. But we are not happy, again! Let me take you through the why…

Low Inflation – NOT a Blessing!

Low Inflation brings with itself own set of problems. To begin with, low food inflation means low food prices. A big Yay for the consumers, but a cause of misery for the producers aka Indian Farmers or some 118.7 million people. Farmers are facing higher costs but are realizing lower revenue, which is adding to their misery.

On the other hand, let us take a look at the scenario in – Corporate India, where Salaries are typically inflation adjusted. Consider a scenario when inflation is 5% and you get an increment of 12 % (higher than the corporate average) to a scenario where inflation is none but, your increment is single digit 7%. In both cases, the real raise is same but, consumer behaviourists have proved that the optimism is higher in case A. Higher optimism translates into higher consumption levels and thereby, higher growth of the economy. Optimal Level of Inflation fires the economy. On the other hand, Low Inflation is an indicator of inherent weakness in the economy. Why are firms shying from Price Increase? Well, because there is no demand.

So what is the optimal rate of Inflation? For a developing country like India, it is pegged at around 4%. Anything much below dampens our prospect of economic growth and anything much above it has its own negative consequences, an extreme case of which can be studied via current day Venezuela. Inflation forms the basis of Monetary Policy with low inflation forming a strong case of rate cut. There emerges another problem of low inflation, usually a pain for developed economies. Though interest rate cut can push inflation, interest rates are range bound and cannot sustain below zero, therefore with persistent low inflation, Monetary Policy loses its power – a case of modern-day Japan!

With inflation at historically low levels, we believe RBI is likely to exercise power of rate cuts to fuel the economy. Very simply put, Interest Rates means higher credit availability or lower debt liability which means higher income, therefore higher demand and an ability to push up prices. When this plays out, it will provide some buoyancy to India’s dismal growth rate at this point. It shall also put the economists at peace because, there is much joy in being at self-derived “optimal” levels though the human science is ever evolving, and we may have a new optimal soon.