Research & Commentary

India’s trend towards deflation

The belief that inflation relates to rising prices of goods and services, and that deflation relates to falling prices, is so widespread that even central bankers (who really should know better) have long ago resigned themselves to describing rising and falling prices in this way. Here’s an interesting thing: I wonder how many people think that that CPI is an acronym for Consumer Price Inflation. It is not. CPI stands for Consumer Price Index. It’s an index of prices that go up and down.

Inflation is an expansion of money and credit in an economy. Deflation is a contraction of money and credit.

The link between the stock of money and credit in an economy and prices of goods and services is not a stable relationship, but sometimes it can be strong. Take India for example.

Our chart shows the year-on-year change in Indian money supply (M3) along with the year-on-year change in the Consumer Price Index. We can see that a strong relationship exists with both measurements declining together in recent years. Both series are still showing positive numbers though. In M3’s case this can be described as disinflation. The CPI is merely advancing at a slower rate.

Semantics aside, this relationship is interesting in India because the Ministry of Finance there recently warned that the economy risks going in to a deflationary period, citing excess private sector debt as one reason. As their report states:

“The Indian boom of the 2000s has not been followed by serious deleveraging. While the slow growth of bank credit in the last two years has been a source of concern, the question may well be not the slowdown but whether there has been enough of it. If deleveraging is a necessary condition for the resumption of rapid growth, perhaps India needs less credit growth — or to be precise more debt resolution and reduction — in the short run”.

In other words, a deflation of credit.

In fact, the narrower measurement of money supply in India, M1, has just experienced a deflationary bout as our chart shows. This came after the trend towards a deflationary mindset manifested in the government’s decision to ban the use of 500 and 1,000 rupee bank notes in November 2016, in an effort to speed the move to a more digital economy, crack down on the gray-economy and cut off a source of funding for criminals and terrorists.

Under this process they called “demonetization”, The M1 money supply deflated and has only just returned to a marginally positive year-on-year growth rate. The decision appeared to come out of the blue, but as our M3 chart shows, a disinflationary bias has been apparent since 2013. Governments are part of the crowd and the laws that they impose generally reflect the trend in mood. So rather than the decision causing the acceleration of disinflation into outright deflation, the disinflation trend already present encouraged the government to impose the law.

Demonetization certainly had an impact on economic activity, mainly due to the wasted time people spent trying to exchange those notes, but it’s interesting to observe that the Indian sociometer – the stock market – took it all in its stride and is up around 20% since last November.

Nevertheless, the disinflation trend of M3 money supply suggests that a broader deflation, including a declining CPI, may be coming.


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