Skip to main content

Deflation - Economics of lower inflation

There are chances of the economy moving into deflation. Here we outlines some implications

The stock markets had a few surprises last week. Here, the inflation rate fell to historic lows. The market participants were now foreseeing a possibility of inflation hitting zero. It just showed how times had changed in a short span of a few months.

Just a while ago, investors were praying for lower inflation numbers every Thursday. But the consistent decline in the inflation numbers has left them pondering whether they got more than what they had bargained for, as India may experience negative inflation WoW soon.

What is deflation?

A temporary dip into the negative side will not be immediately considered as deflation. Deflation should not be confused with a temporary fall in prices. It is a sustained fall in prices that occurs when the inflation rate passes down below zero percent. In a deflationary environment, the price of goods and services keep falling. Hence, consumers have an incentive to delay purchases and consumption until prices fall further. This in turn reduces the overall economic activity.

There is a fall in the quantum of goods and services the whole economy is willing to buy, and the price they are willing to pay for goods and services. Since this idles capacity, investments also fall, leading to further reductions in aggregate demand. Deflation also has the side effect of increased unemployment since there is a lower level of demand in the economy. A lower employment level further slows down the demand, thereby contributing to the deflationary spiral.

The appearance of deflation as a widespread global phenomenon is indeed disturbing, not only because of its immediate economic implications, but because until recently most economists regarded sustained deflation as a fundamentally implausible prospect.

Deflation increases purchasing power

Deflation increases the real value of money. It benefits savers and of holders of liquid assets and currency as the real value of liquid assets and currencies keeps increasing as time lapses. On the other hand, it erodes the wealth of investors who have invested in illiquid assets, and borrowers as the value of money invested in an illiquid asset today will be worth less as time goes by.

It also amplifies the quantum of borrowings and is a significant disincentive to borrowers. The payments one is making in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency. It increases the purchasing power of money as time goes by. However, it can cause hardship when the majority of one's net worth is held in illiquid assets.

Way out of deflation

Deflation, at least in theory, is easy to prevent. The government has to just print more money. Printing money is normally a pleasant experience for all governments. Printing more money increases the quantum of money in circulation making it easy for people to spend.

Another measure to counter deflation is monetary policy operations by the central bank. By buying government bonds they increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because it increases profits and takes some of the depressive pressures off wages and debtors of every kind.

Impact on investor

Hence, there could be more rate cuts and monetary easing from the Reserve Bank of India. The markets are factoring in a rate cut of 100 basis percentage points. Monetary easing could also take the form of buying government bonds in open market operations.

For individual investors, it also implies that the days of high deposit rates of 10-12 percent are a thing of the past and they will get lower returns on their deposits and fixed instruments. Individual investors who have invested in fixed deposits and bonds will find the intrinsic value of the instruments will increase during deflationary periods.

Popular posts from this blog

Tata Mutual Fund

Being a part of the Tata group, the fund has the backing of a very trusted brand name with strong retail connect. While the current CEO has done an excellent job in leveraging the Tata brand name to AMC's advantage, it is ironic that this was just not capitalised on at the start. Incorporated in 1995, Tata Mutual Fund remained an 'also-ran' fund house for around eight years. Till March 2003, it had a little over Rs 1,000 crore in assets and 19 AMCs were ahead of it. But soon after that the equation changed. It was the fastest growing fund house in 2004 and 2005. During these two years, it aggressively launched six equity funds, two debt funds and one MIP. The fund house as of now stands at No. 8 in terms of asset size. This fund house has a lot to offer by way of choice. And, it also has a number of well performing schemes. Tata Pure Equity, Tata Equity PE and Tata Infrastructure are all good funds. It also has quite a few good debt funds. The funds of Tata AMC are known to...

UTI Mutual Fund

Even though only a few of UTI’s funds are great performers, this public sector fund house has many advantages that its rivals do not. It has a huge base of retail equity investors and a vast distribution network. As a business, it looks stronger than ever, especially in the aftermath of credit crunch. UTI is, by a large margin, the most profitable fund company in the country. This is not surprising, since managing equity funds is more profitable than debt. Its conservative approach and stable parentage is likely to make it look more attractive to investors in times to come. UTI’s big problem is the dragging performance that many of its equity funds suffer from. In recent times, the management has made a concerted effort to improve performance. However, these moves have coincided with a disastrous phase in the stock markets and that has made it impossible to judge whether the overhaul will eventually be a success. UTI’s top performers are a few index funds, some hybrid funds and its inf...

Salary planning Article

1. The salary (basic + DA) should be low. The rest should come by way of such allowances on which the employer pays FBT and you don't pay any tax thereon. 2. Interest paid on housing loan is deductible u/s 24 up to Rs 1.5 lakh (Rs 150,000) on self-occupied property and without any limit on a commercial or rented house. 3. The repayment of housing loan from specified sources is also deductible irrespective of whether the house is self-occupied or given on rent within the overall ceiling of Rs 1 lakh of Sec. 80C. 4. Where the accommodation provided to the employee is taken on lease by the employer, the perk value is the actual amount of lease rental or 20 per cent of the salary, whichever is lower. Understandably, if the house belongs to a family member who is at a low or nil tax zone the family benefits. Yes, the maximum benefit accrues when the rent is over 20 per cent of the salary. 5. A chauffeur driven motor car provided by the employer has no perk value. True, the company would...

8 Investing Strategy

The stock market ‘meltdown’ witnessed since the start of 2005 (notwithstanding the recent marginal recovery) has once again brought to the forefront an inherent weakness existent in our markets. This is the fact that FIIs, indisputably and almost entirely, dominate the Indian stock market sentiments and consequently the market movements. In this article, we make an attempt to list down a few points that would aid an investor in mitigating the risks and curtailing the losses during times of volatility as large investors (read FIIs) enter and exit stocks. Read on Manage greed/fear: This is an important point, which every investor must keep in mind owing to its great influencing ability in equity investment decisions. This point simply means that in a bull run - control the greed factor, which could entice you, the investor, to compromise with your investment principles. By this we mean that while an investor could get lured into investing in penny and small-cap stocks owing to their eye-...

Debt Funds - Check The Expiry Date

This time we give you an insight into something that most debt fund investors would be unaware of, the Average Portfolio Maturity. As we all know, debt funds invest in bonds and securities. These instruments mature over a certain period of time, which is called maturity. The maturity is the length of time till the principal amount is returned to the security-holder or bond-holder. A debt fund invests in a number of such instruments and each of these instruments would be having different maturity times. Hence, the fund calculates a weighted average maturity, which would give a fair idea of the fund's maturity period. For example, if a fund owns three bonds of 2-year (Rs 30,000), 3-year (Rs 10,000) and 5-year (Rs 20,000) maturities, its weighted average maturity would be 3.17 years. What is the big deal about average maturity then, you may ask. Well, knowing a fund's average maturity is important because it tells you how sensitive a fund is to the change in interest rates. It is ...
Related Posts Plugin for WordPress, Blogger...
Invest in Tax Saving Mutual Funds Download Any Applications
Transact Mutual Funds Online Invest Online
Buy Gold Mutual Funds Invest Now