Edelweiss:Deflation realities come closer

The consumer price index (CPI) in the US plunged 1% M-o-M in October, the lowest in a single-month since 1947. Also, this is the third consecutive month of negative M-o-M CPI growth in the US. Such an event has never taken place in the US since December 2001.

The core CPI [CPI ex food and energy], at (-0.1%) M-o-M, has also turned negative in October for the first time since December 1982. This is definitely indicative of a broad-based downward pressure on prices, following lack of demand.

Early signs of deflation across the globe as well :World growth is projected to witness a significant slowdown over the next year. The November 2008 update of the World Economic Outlook (WEO) of the International Monetary Fund (IMF) projected world GDP growth to slow down from ~5% in CY07 to ~3.75% in CY08 and to just over 2% in CY09.

Growth outlook has dipped significantly, particularly in case of advanced economies, and concerns are high on rising unemployment. As per IMF, activity in advanced economies is now expected to contract ~0.25% in CY09. This would be the first annual contraction after the World War II. With the slowdown in real activities, demand is falling for most commodities across the globe. Such slowdown in demand has led to a crash in commodity prices globally.

In today’s globalised world, several emerging economies (including India) are exposed to the possibility of importing deflation. Over the last three months, the wholesale price index (WPI)-based inflation declined from ~13% to ~9%, Y-o-Y. As a whole, given the trends in international commodity prices, further correction in domestic commodity prices (with the possible exception of agricultural commodities) is a foregone conclusion. In fact, even if no prices change over the next one year, we will still have a spell of negative inflation during July-October next year.

Likely policy reaction across countries Deflationary expectations may also affect smooth functioning of the financial system on the back of: (a) fears of weakening of banks’ balance sheets from reduced value of collaterals; (b) increased real burden on debtors to service loans; and (c) widening of risk premium on corporate bonds. To avoid such adverse consequences of deflation, the common set of measures typically adopted by policy makers are as follows:

Strong easing of monetary policy. Stepping up of fiscal expenditure to boost domestic demand. Financing of augmented government expenditure by central banks, typically through deficit financing and/or open market purchases of government bonds.

Allowing depreciation of the domestic currency. In case of the US, the Fed has already been ultra-aggressive in cutting interest rates. The target Fed funds rate has been brought down from 5.25% to the current 1% within just 13 months. Expectations are widespread that the Fed will further cut the target Fed funds rate in the FOMC meeting on December 16. Most other advanced economies, including the UK, Euro zone, and Japan, are also reducing their interest rates aggressively. Theoretically, they can drag the rate down to even zero. But, even in that case, the residual headroom available to some of the advanced economies’ central banks appears limited at this moment. Thus, parallel to monetary policy measures, infusing strong fiscal stimulus by the respective governments is inevitable at this juncture. As the first step, governments may cut taxes further. In case of consumption-driven economies, enhanced disposable income is likely to augment consumption and boost demand in the economy. In the current environment of widespread recession across several major economies, countries with structurally higher domestic demand will have an in-built resilience. Enhanced fiscal expenditure will also have more direct impact in case of such countries.

With shattered financial market confidence for most countries, another effective policy stimulus at this moment can be government guarantee for banks and financial institutions on the loans they extend. In case of additional government guarantee on loans, financial institutions may be more comfortable extending credit. However, such government guarantee would have to be designed to pre-empt the likelihood of possible moral hazards i.e., to tackle the issue of further erosion of credit quality.

And, above all, there has to be additional direct government spending to help boosting demand in the economy. In the current situation of slowing demand across segments, the most effective and instant route of boosting demand is high government spending, particularly in areas of infrastructure. Such policies have been adopted widely and aggressively by countries all over the world. We are likely to see more of such concentrated packages from several other countries.

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