It's deflation, stupid!

Central bank’s focus on curbing consumer inflation may be counter-productive 

India’s GDP deflator (the measure of economy-wide inflation) for the quarter Jul-Sep 2015 (Q2 FY16) is -1.4%. While a positive value of the deflator signifies that the economy is experiencing inflation, a negative value, as is the case currently, suggests that the economy is in deflation. The economy-wide inflation measure has been falling consistently since 2012 (See chart: Uncomfortable reversal). Falling inflation is a good thing but when the GDP deflator fell to 1.8% in Q1FY16, it was rather ‘too much’ of a good thing. If the revised GDP estimates also throw up a negative value for GDP deflator then it will confirm that India has technically entered the deflation zone in Q2FY16.

While the real GDP growth for Q2FY16 stands at 7.4%, the recovery in the economy may be more numerical than ‘real’. Let’s understand how. The GDP is first estimated using current prices existing as of that period and such a GDP is called nominal GDP. To compare the economic activity across time-periods the nominal GDP is adjusted for, by the economy wide inflation measure (-the GDP deflator) to calculate the real GDP.

To the extent inflation exists in an economy, the nominal GDP (as well as nominal GDP growth) is higher and it gets deflated to estimate the real GDP (or real GDP growth). However, when an economy enters deflation, the nominal GDP is lower than the real GDP. As per recent estimates this has been the case for the Indian economy in Q2 FY16 where the real GDP was 7.4%. However, the nominal GDP is only 6.0%.

It may be worthwhile to remember that the economy in which we live, earn and spend is captured by the nominal GDP. This current nominal GDP growth is among the worst in a decade. This can also be seen in corporate performance which is arguably the weakest in a decade. Besides, other measures of economic health such as industrial loan growth is at an unheard low single digit. Most would say that for an emerging economy deflation is as worrisome, if not more, than high inflation. This usually calls for sharp reduction of interest rate by the central bank.

Likewise the government may take coordinated action of reviving spending, so that the economy does not enter into a ‘deflation trap’. Surprisingly in India, the RBI and the government are celebrating the 7.4% real growth and the urgency to deal with ‘deflation’ has not been quite visible. Hypothetically, in one of the upcoming quarters India may hit a real GDP growth of 8% and can exhibit a nominal GDP growth of 5% and a GDP deflator of -3%. Some may celebrate the return to “8% growth”. However, if this happens it will imply that the economy has slipped further into deflation!

False dawn

Before the debate on the new GDP Series (Base Year 2011-12) has settled down, Indian inflation metrics are presenting new challenges to monetary policy making. The Wholesale Price Index (WPI), representative of industrial inflation, has been exhibiting negative growth (deflation) for last several quarters. However, the consumer price inflation, which have moderated from 2013-14 continues to remain in the 4% to 6% range. As has been the case in the past, the GDP deflator has more closely mirrored the WPI. Given the continued deflationary trend of WPI, India’s GDP deflator may continue in the negative territory thereby implying deflationary pressure on the economy. However, the CPI may continue to exhibit values in excess to 4% to 5%.

RBI has adopted the recommendation of Urjit Patel Committee Report. The report has adopted Consumer Price Inflation (CPI) as the nominal inflation anchor. Which means RBI will focus on CPI as a measure of inflation in its monetary policy decisions.The period of analysis that was used during the Urjit Patel committee’s research did not throw up such a long period, where WPI (as well as GDP deflator) diverged so significantly from CPI. However, as with most economic data it is risky to assume that just because it has not happened in the past, it will not happen in future.

The current GDP deflator suggests that the economy is possibly entering a deflation zone while CPI continues to exhibit a moderately high inflation level. It is possible that if RBI continues to focus only on CPI as an inflation measure (in line with Urjit Patel Committee Report) and neglects GDP deflator altogether, the economy may slip further into deflation. The implication being that corporate earnings as well as corporate debt servicing ability, which closely tracks nominal GDP, will keep on deteriorating while the inflation adjusted GDP(or real GDP) may continue to exhibit a 7% plus growth rate.

If CPI remains well above 4%, RBI may cite that as a reason for not cutting the interest rate. With GDP deflator in negative territory, India’s real interest rate (nominal interest rate less systemic inflation) may currently be well in excess of 8%, a level not seen in over a decade. Historically, ‘high’ real interest level for India has been around 6%. That leaves room for a rate reduction of atleast 100 basis points. But to take such a decision the RBI needs to give some weight to holistic measures of economy-wide inflation such as GDP deflator and not restrict itself only to CPI as the sole measure of inflation.

The author is a visiting faculty at IIM Calcutta. Views are personal.