Inflation at 0.44%…what next?

A combination of falling food articles & fuel prices and a high base effect from last year have led inflation this week to the historical low of 0.44%. The numbers were lower than the forecasted figure of 0.89% of Reuters but certainly in line with the trend that economy had expected. Annual inflation as measured by Wholesale Price Index was at 2.42% in the week before and at 7.78% in the corresponding week last year.

Fuels and metals prices being far lower than last year, along with low demand in the economy gave this higher base year effect. Now, there are talks of Deflation. Market men are expecting the inflation will head towards zero level in 3-4 weeks and soon in negative territory for 4 to 5 months, which will open the way for the Reserve Bank of India to cut interest rates further to grow up demand and economic growth.

First of all, we need to know what exactly deflation is. In Inflation, money becomes relatively less valuable than goods. And deflation being the exact opposite of inflation, money becomes more valuable than the other goods in the economy. And when does deflation occur? It usually occurs when supply of goods is more than supply of money. So demand for money goes up and demand for goods goes down. Does this mean that we are now talking of a fall in inflation caused by falling demand? Well, if we see the IIP numbers of Dec/Jan, especially the falling growth rate of the manufacturing sector, it conveys the same. So, in the coming few months, market is expecting negative Inflation.

With inflation at its historic low, the consensus in the market are like in terms of policy response, RBI will ease the liquidity by cutting both the REPO and reverse REPO rates by 100 basis points by mid-2009. But RBI has already taken so many measures in the past few months, now the onus is on the banks. Rather than concentrating on what the central bank is doing, we have to really see is what the cost of funds is for the banks, and that requires lower deposit rates. The banks have reduced the interest rates on bulk deposits, which is at an average of 10% while it has not really reduced the lending rates, which continues to remain at an average of 12%, which is the PLR. Banks have become risk averse to the extent of being over cautious. Unless the banks are not able to redeem the high interest cost deposits, the rates are not expected to come down. One could see rates coming down in the slack season between April-September 2009. Once RBI reduces the rates, then deposit rates could come down further and it is only after that, that the banks will reduce lending rates. Then only we can see some industrial demand.

We cannot say that we will actually see Deflation very soon, because to some extent, the current condition is just an eyewash. The gap between WPI and CPI is further widening. WPI Inflation as measured by RBI is 0.44 %, but the Retail inflation as measured by the consumer price index has moved up to 10.45% in January, the highest since December 1998.

Now the question arises, why prices at the retail level are not coming down – in spite of the WPI based inflation coming to 0.44 %.

Well, when inflation goes down, the process starts from the supplier of raw materials like in case of housing industry, the process starts from the iron-ore–>Steel industry –>Trader–>Construction industry –> Home owner. So just imagine the effective time which inflation takes to reach to the ultimate real consumer. The iron ore just mined out may take around 1-2 years to reach our home, which is under construction. By that time, inflation goes up again, the trader, who purchased steel cheap, raises his prices to match the current prices and the steel becomes costly again so we don’t find the difference in our daily-lives.

So, the recessionary trends will not go away and demand will not pick up until things change at the retail level because ultimate buyer of everything is common man only. In addition to this, sentiments should improve.

The asset price bubble, which was basically built from the abnormal increase in the prices of real estate, heavy FII money in the equity markets etc. in the past, had made India as a “high cost economy”. So, the deflation at -5 to -10 % is required to restore competitiveness of the Indian economy. This rolls the current price levels to few years back and restores sanity in the market place.

But if deflation sustains for longer period of time, it will result in less demand, lower production and weak economic growth.

So, in this scenario, investors should invest in those companies where decline in prices lead to increase demand for their products, prompting them to produce more value-added products with greater economies of scale. Companies, operating in sectors like snacks and beverages, health care, utilities and telecommunications can be a good buy. Apart from this, companies with strong balance sheets, which do not have much debt on their books, can also be considered for investment like IT, health care and energy sectors.

Though negative inflation is not good from a growth point of view but India’s low inflation rate for 5-6 months will not be a cause of worry as it will enable policy makers to take more steps to stimulate a slowing economy and if some more monetary easing is done, economy can see some revival in demand due to decrease in lending rates.