Inflation/Deflation/Recession/Depression/Currency

As posted in my previous posting, inflation came down to 6.84% from 8%. From one angle its good thing that it’s coming down. But from other angle, I see there are two problems which may arise in near future.

Number one problem is what WPI (Whole Price Index) numbers what we are getting are not indicating the exactly what a common is paying for day to day life expenditure. Then you may ask why there is difference? First, WPI is not a retail customer cost driven number. Second is YoY (Year on Year) measurement. [In this method, presently they consider 1993-94 as the base year taking 100 as the base. Here they compare this year data with last year’s respective week’s data by ultimately comparing it to base year that is 93-93. And for calculation they use Laspeyre’s formula, for which base year should be changed frequently]. Take the example of present condition, almost from January/February 2008 our inflation started heading towards north direction. So now coming months that is January/February 2009 when they compare with last year’s rising data, obviously we get lesser value as WPI numbers. That may not be exact value even what the wholesale dealers are paying. Third is different products & weightage to them in the WPI list is not updated as per the current requirements & demands in the market. As I mentioned above, list of items/commodities of WPI series is updated in 93-94. In that not even a single service is added where as more than 50% of our present economy depends on the service sector. Out of 435 total items, WPI series is overloaded with 318 manufactured products with a Weightage of 57% to it. These are main problems due to which inflation (WPI) numbers are not depicting the present conditions. So for this I think government should think adapting to CPI (Consumer Price Index) with MoM (Month on Month) as base and modifying the list of items/commodities according to country’s GDP growth.

Now second problem regarding the inflation is the pace at which it is falling! As I mentioned in the above paragraph, due to base effect pace may increase and also widen in coming days. In addition to that there is possibility another round of price reduction in the Petrol, Diesel & Gas also this time (which have nearly 14% weightage in WPI series). If this happens WPI numbers may start giving DEFLATION instead of INFLATION numbers. And DEFLATION is very much possible in this kind of economic scenario where day by day economic contraction is happening.

Now coming to domestic demand, how government is going to improve the demand in the market. Looking at October month’s IIP (Index of Industrial Production) numbers of manufacturing sector and overall we are also facing the threat of recession. And exactly this is what Keynes said, PARADOX OF THRIFT. Means if everyone starts saving money during times of recession, then there is decrement in the consumption which leads to fall in the aggregate demand thus leads to a fall in economic growth. If this continues then there will be downsizings & mass layoffs which are already started, eventually it leads to stagnation in the savings of total population or even declined because of lower incomes and a weaker economy.

So how RBI or Government is going to handle condition? Only by using monetary policy that is by reducing the interest rates. From 1990s Japan is using this tool to come out of its economic crisis but without success. BoJ (Bank of Japan) kept its main rate at 0 from 2001 to 2006 while flooding the banking system with extra cash to encourage lending, spur growth and overcome deflation. But what’s the success? Again it’s in recession now. Its stock market (Nikkei 225) hasn’t able to retrace back the peak level what it achieved in 1990 that is 40000 levels, which is presently trading around 8500 levels.

Or fiscal policies like stimulus packages which again can be questionable in terms of implementation and immediate relief they are going to provide?

Now apart from above mentioned problems, country may face the problem of rupee appreciation near future! As we all know 2 largest economies US & Japan have reduced their interest rates to almost zero. And many more are following in that direction only to avoid the depression as recession has already started in their countries. And above all there is possibility that large stimulus package as much as $ 850 Billion from US and $ 990 Billion from Japan. Think about the vulnerability their fiscal deficit in percentage terms of their respective GDPs. So obviously there is possibility of INTEREST RATE PARITY which in turn cause the rupee appreciation which already started from 50+ to around 47 a US $. Rupee depreciation/appreciation is a very sensitive issue which linked to country’s BOP in terms of export & imports. In this crisis time where export oriented firms are facing the heat of contraction in their orders and this rupee appreciation add to their pain. So what would be the RBI/Government’s stand in this case? Whether will it go FOREX RESERVE CONTENT or CURRENCY MAINTAINANCE? How they are going to maintain GDP growth in spite of reduction in export orders.

Problem will not end here, even if somehow RBI/Government maintains everything in balance, problem of using the inflow of funds effectively! Because of this problem only ASIAN CURRENCY CRISIS originated.


Bottom-line:

In an economy each and everything is interlinked. We can call it VICIOUS CIRCLE. Even if one thing changes then there will be changes in all the links in that CIRCLE. So RBI/Government needs to take balanced steps to avoid the near term problems and also keeping in mind the possibility problems arising in long term from these steps.