With crude oil prices tumbling from peak of $147 a barrel in July to below $ 40 a barrel in recent days and prices of non-oil commodities have declined by more than 40%, implies the journey from inflation to deflation in recent months.
The glossary of economics terms define deflation as occurring "when prices are declining over time".
This is opposite of inflation: when inflation rate (by some measure) is negative the economy is in a deflationary period.
In past few months, the major challenge before governors of central banks of all countries was to fight economic danger of inflation, led by rising food and oil prices.
However in past 2 months the whole picture has seemed to be reversed, with deflation turning out to be credible and is much more threatening than most people realize.
Deflation was last witnessed in great depression of 1929.
Consumer prices fell about a quarter in 1929 to 1933.
Spending crumpled.
Supply overpowered demand, driving prices down.
By 1933 manufacturing output had dropped by 39% and unemployment was around 25%.
Therefore current job of policymakers would be to ensure that deflation does not take over and turn these crises into a disaster.
If we look at the figures of inflation over past few months, it could be witnessed that journey from inflation to deflation has been too fast.
Inflation in America had reached to a level of 5.
6% in July, highest since 1991, while for Europe inflation recorded was 4% in the same month.
The first half of 2008 was stormed by rising food prices world wide.
The aggregation of rising energy prices, use of food crops for biofuels and torpid food aid has threatened food security of many developing countries.
Globally agricultural commodity prices were significant during 2004-06: corn prices rose 54 %, wheat 34%, soybean oil 71% and sugar 75%.
But this trend hastened in 2007, due to continued demand for biofuels and drought in major producing countries.
Wheat prices have risen more than 35 percent since the 2006 harvest, while corn prices have increased nearly 28 percent.
The price of soybean oil has been particularly volatile, due to high demand growth in China, the U.
S.
, and the European Union (EU), as well as lower global stocks.
Estimated results of food and agriculture organization of United Nations shows that the high food prices of 2006 increased the food import bill of developing countries by 10 percent over 2005 levels.
For 2007, the food import bill for these countries increased at a much higher rate, an estimated 25 percent.
However after first half this commodity boom has turned out to be bust which changed the inflation scenario significantly.
For instance the price of a barrel of crude oil has tumbled from a peak of $147 in July to below $40 in recent days.
The index of non-oil commodity prices has fallen by 40% since July.
If raw-material prices remain at these lower levels, the year-on-year change in the retail prices of food and fuel will turn sharply negative in 2009.
Deflation is caused by decline in the aggregate demand.
A sustained decline in demand also leads to recession but not all recessions have deflation.
Hence, deflation automatically implies recession and leads to a downward spiral in an economy.
As economies falls into deeper recession and spending decreases, firms will have to fight harder for sales by pricing their goods fiercely.
Oversupply can be witnessed in America's job market, with unemployment rate reaching to a level of 6.
5% in October.
Effects of fall in food prices can be witnessed in emerging economies, such as inflation in china has fell to 4% in October from peak of 8.
7% in February, whereas in India inflation is at levels of 6.
84% from peak of 12% in July.
In developed economies America is more likely to be hit by period of deflation than Europe.
The reason of this is crude oil costs, which accounts for larger part of budget of Americans consumers which they spend on petrol.
Motor fuel also forms a large part of their spending so falling prices will depress inflation by more.
Markets are tending to be more flexible in America, therefore prices turns out be less sticky and respond readily to economic conditions.
The year on year fall in oil prices is likely to be steepest in the third quarter next year when the base will be this summer's peak.
Estimations of various economists are that America's inflation rate will briefly turn negative at that point.
Now if ones goes by logic, commodity led fall in inflation is a good sign for rich economies.
It boosts consumers' real purchasing power and increases firm's profit margins.
But beyond a few percentage points' deflation can lead to a economic mayhem by forcing the debtors to pay loans in more expensive money and causing consumers to postpone purchases.
This deadly mixture of falling prices and high leverage could stem up "debt deflation".
Debt deflation in simple terms is explained in following example: "A mortgage, which is a form of secured debt, presents a good example.
Let's say you purchased a home by taking out a mortgage.
That same home would be secured as collateral for the loan, meaning that if you defaulted on payments to the bank, the home would be repossessed by the bank.
If the potential selling price of the home decreased in value while you were still making payments to the bank, you would be in the middle of a debt deflation scenario.
" Under debt deflation debt laden firms and consumers rush to pay loans as credit dries up.
That leads to decrease in demand and results in price cuts.
Therefore deflation in turn increases the cost of debt.
Recent lending surveys by the Federal Reserve and the ECB showed a larger share of banks tightened their lending criteria in October than in July.
Such is the concern in America that on November 12th regulators said they would scrutinize the dividend policies of banks that did not increase lending.
The surveys also revealed hesitancy to borrow, which matches with signs of decline in spending.
With the collapse of Lehman brothers, trust among financial institutions evaporated.
Credit spreads- the gap between commercial interest rates and rates on safe treasury securities- exploded.
Stock markets crashed.
Economies all over the world sweep downwards.
Prices for basic commodities, feedstock of modern economies, witnessed major break.
Prices of these commodities knocked about from historical highs that were majorly attributed to strong demand from emerging economies like China and India.
Suddenly prices plummeted.
Not only oil recorded a highest fall but metals like copper recorded a fall of about $8900 a metric ton in June to $3800 and aluminum from $ 3000 a ton to $ 1900.
In theory lower commodity prices could be a boon, if propensity to spend among consuming nations is more than the producing nations.
In such a scenario lower prices would lead to global recovery.
But according to many economists lower commodity prices may proclaim a broader deflation.
This cycle would work in the following way: Debt: As prices fell and old debt stayed fixed, companies would be facing difficult times in repaying these debts; bankruptcies and unemployment will increase; banks would suffer more loan losses ; if wages fell then same would be the case with household debts.
Deferred spending: If people believe that prices will be lower next month, they may wait to buy and if too many shoppers wait, the economy would coil downwards.
In order to fight this phantom of deflation, governments are doing much by slashing interest rates.
But given the reluctance of many banks to lend and households to borrow, the effect may turn out to be nil.
Is India facing a risk of deflation? If we look at current inflation numbers for India, it stands at 6.
84%.
This fall in prices is led by fall in crude oil, commodities and prices.
So does this imply that India also has risk of deflation? According to many analyst and economists possibilities of deflation in India are slight.
Many reasons can be factored out for this: Firstly India has taken various policy measures to buffer the economy.
Repo rate, SLR and CRR have already been slashed.
CRR can be brought down to about 3% (RBI's medium term goal).
All these measures in turn would infuse liquidity into the economy.
It is estimated that these measures would result in additional release of Rs 2, 88, 000 crore into the system.
Secondly fiscal dole outs such as 6th pay commission award, farm loan wavier, income tax exemptions and employment guarantee scheme will put Rs 1,20,000 crore (2.
5% of GDP) into the system in turn boosting consumption demand.
Thirdly the current declining inflation is just a one time number, with no trend and could be revised upwards.
Private consumptions still forms around 60% of GDP and is expected to be steady and is expected to be steady, preventing prices from falling due to lack of demand.
Lastly if we look at Indian banking system, it is quite safe and sound with capital adequacy ratio of most banks being at 12% against the mandatory 9%.
The money multiplier will have to rise to meet growing demand for funds, subject to additional capital with banks.
While NPAs will rise as the economy slows, net NPAs at 1% of total assets provide comfort.
More importantly, housing/realty is
The glossary of economics terms define deflation as occurring "when prices are declining over time".
This is opposite of inflation: when inflation rate (by some measure) is negative the economy is in a deflationary period.
In past few months, the major challenge before governors of central banks of all countries was to fight economic danger of inflation, led by rising food and oil prices.
However in past 2 months the whole picture has seemed to be reversed, with deflation turning out to be credible and is much more threatening than most people realize.
Deflation was last witnessed in great depression of 1929.
Consumer prices fell about a quarter in 1929 to 1933.
Spending crumpled.
Supply overpowered demand, driving prices down.
By 1933 manufacturing output had dropped by 39% and unemployment was around 25%.
Therefore current job of policymakers would be to ensure that deflation does not take over and turn these crises into a disaster.
If we look at the figures of inflation over past few months, it could be witnessed that journey from inflation to deflation has been too fast.
Inflation in America had reached to a level of 5.
6% in July, highest since 1991, while for Europe inflation recorded was 4% in the same month.
The first half of 2008 was stormed by rising food prices world wide.
The aggregation of rising energy prices, use of food crops for biofuels and torpid food aid has threatened food security of many developing countries.
Globally agricultural commodity prices were significant during 2004-06: corn prices rose 54 %, wheat 34%, soybean oil 71% and sugar 75%.
But this trend hastened in 2007, due to continued demand for biofuels and drought in major producing countries.
Wheat prices have risen more than 35 percent since the 2006 harvest, while corn prices have increased nearly 28 percent.
The price of soybean oil has been particularly volatile, due to high demand growth in China, the U.
S.
, and the European Union (EU), as well as lower global stocks.
Estimated results of food and agriculture organization of United Nations shows that the high food prices of 2006 increased the food import bill of developing countries by 10 percent over 2005 levels.
For 2007, the food import bill for these countries increased at a much higher rate, an estimated 25 percent.
However after first half this commodity boom has turned out to be bust which changed the inflation scenario significantly.
For instance the price of a barrel of crude oil has tumbled from a peak of $147 in July to below $40 in recent days.
The index of non-oil commodity prices has fallen by 40% since July.
If raw-material prices remain at these lower levels, the year-on-year change in the retail prices of food and fuel will turn sharply negative in 2009.
Deflation is caused by decline in the aggregate demand.
A sustained decline in demand also leads to recession but not all recessions have deflation.
Hence, deflation automatically implies recession and leads to a downward spiral in an economy.
As economies falls into deeper recession and spending decreases, firms will have to fight harder for sales by pricing their goods fiercely.
Oversupply can be witnessed in America's job market, with unemployment rate reaching to a level of 6.
5% in October.
Effects of fall in food prices can be witnessed in emerging economies, such as inflation in china has fell to 4% in October from peak of 8.
7% in February, whereas in India inflation is at levels of 6.
84% from peak of 12% in July.
In developed economies America is more likely to be hit by period of deflation than Europe.
The reason of this is crude oil costs, which accounts for larger part of budget of Americans consumers which they spend on petrol.
Motor fuel also forms a large part of their spending so falling prices will depress inflation by more.
Markets are tending to be more flexible in America, therefore prices turns out be less sticky and respond readily to economic conditions.
The year on year fall in oil prices is likely to be steepest in the third quarter next year when the base will be this summer's peak.
Estimations of various economists are that America's inflation rate will briefly turn negative at that point.
Now if ones goes by logic, commodity led fall in inflation is a good sign for rich economies.
It boosts consumers' real purchasing power and increases firm's profit margins.
But beyond a few percentage points' deflation can lead to a economic mayhem by forcing the debtors to pay loans in more expensive money and causing consumers to postpone purchases.
This deadly mixture of falling prices and high leverage could stem up "debt deflation".
Debt deflation in simple terms is explained in following example: "A mortgage, which is a form of secured debt, presents a good example.
Let's say you purchased a home by taking out a mortgage.
That same home would be secured as collateral for the loan, meaning that if you defaulted on payments to the bank, the home would be repossessed by the bank.
If the potential selling price of the home decreased in value while you were still making payments to the bank, you would be in the middle of a debt deflation scenario.
" Under debt deflation debt laden firms and consumers rush to pay loans as credit dries up.
That leads to decrease in demand and results in price cuts.
Therefore deflation in turn increases the cost of debt.
Recent lending surveys by the Federal Reserve and the ECB showed a larger share of banks tightened their lending criteria in October than in July.
Such is the concern in America that on November 12th regulators said they would scrutinize the dividend policies of banks that did not increase lending.
The surveys also revealed hesitancy to borrow, which matches with signs of decline in spending.
With the collapse of Lehman brothers, trust among financial institutions evaporated.
Credit spreads- the gap between commercial interest rates and rates on safe treasury securities- exploded.
Stock markets crashed.
Economies all over the world sweep downwards.
Prices for basic commodities, feedstock of modern economies, witnessed major break.
Prices of these commodities knocked about from historical highs that were majorly attributed to strong demand from emerging economies like China and India.
Suddenly prices plummeted.
Not only oil recorded a highest fall but metals like copper recorded a fall of about $8900 a metric ton in June to $3800 and aluminum from $ 3000 a ton to $ 1900.
In theory lower commodity prices could be a boon, if propensity to spend among consuming nations is more than the producing nations.
In such a scenario lower prices would lead to global recovery.
But according to many economists lower commodity prices may proclaim a broader deflation.
This cycle would work in the following way: Debt: As prices fell and old debt stayed fixed, companies would be facing difficult times in repaying these debts; bankruptcies and unemployment will increase; banks would suffer more loan losses ; if wages fell then same would be the case with household debts.
Deferred spending: If people believe that prices will be lower next month, they may wait to buy and if too many shoppers wait, the economy would coil downwards.
In order to fight this phantom of deflation, governments are doing much by slashing interest rates.
But given the reluctance of many banks to lend and households to borrow, the effect may turn out to be nil.
Is India facing a risk of deflation? If we look at current inflation numbers for India, it stands at 6.
84%.
This fall in prices is led by fall in crude oil, commodities and prices.
So does this imply that India also has risk of deflation? According to many analyst and economists possibilities of deflation in India are slight.
Many reasons can be factored out for this: Firstly India has taken various policy measures to buffer the economy.
Repo rate, SLR and CRR have already been slashed.
CRR can be brought down to about 3% (RBI's medium term goal).
All these measures in turn would infuse liquidity into the economy.
It is estimated that these measures would result in additional release of Rs 2, 88, 000 crore into the system.
Secondly fiscal dole outs such as 6th pay commission award, farm loan wavier, income tax exemptions and employment guarantee scheme will put Rs 1,20,000 crore (2.
5% of GDP) into the system in turn boosting consumption demand.
Thirdly the current declining inflation is just a one time number, with no trend and could be revised upwards.
Private consumptions still forms around 60% of GDP and is expected to be steady and is expected to be steady, preventing prices from falling due to lack of demand.
Lastly if we look at Indian banking system, it is quite safe and sound with capital adequacy ratio of most banks being at 12% against the mandatory 9%.
The money multiplier will have to rise to meet growing demand for funds, subject to additional capital with banks.
While NPAs will rise as the economy slows, net NPAs at 1% of total assets provide comfort.
More importantly, housing/realty is
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