Expectations influence spending. Since expectations have not changed much, we would expect household consumption patterns to remain much the same. But, poll respondents are likely to be wrong not only in their large overestimates of inflation levels but in direction.
Most Indians would instinctively consider low inflation, or even deflation, to be a good thing. However, low inflation can cause problems and deflation can lead to terrible situations. Deflation can lead to full-blown depression, when gross domestic product (GDP) contracts. In deflationary situations, industries and farmers cannot get decent prices for their goods. Say, a manufacturer borrows, invests, hires personnel and buys raw materials. If prices fall, the manufacturer might be forced to sell at a loss and not be capable of servicing debt. Situations like this lead to lower demand up and down value chains, and result in job losses. Inevitably, deflation hits services, too.
This can become a vicious cycle. As inflation has fallen, many businesses have struggled and been unable to service debts. A recent report by Credit Suisse reckons 40 per cent of corporate debt is held by businesses with interest coverage ratios of less than one. The ratio is derived by dividing operating profits by interest expenses. A ratio below one indicates debt is unserviceable.
Credit demand has fallen to historic lows. This has contributed to the crisis, with non-performing assets (NPAs) running at 10 per cent of GDP. Demonetisation hit the informal economy and triggered food deflation as well. That has led to farmer protests. Huge farm loan waivers will create stresses on government finances and hurt banks’ balance sheets.
The central bank targets CPI inflation at around four per cent, with a band of plus/minus two per cent. At 2.2 per cent, the May numbers are very close to the minimum tolerance level. It is likely the RBI will cut rates soon.
The hope would be that lower rates would create demand from both corporates and consumers. However, it’s an open question if banks can pass on cuts, given the poor balance sheets. Even if they do cut rates, credit demand might remain muted. Corporates are wary of investing because they see low demand and many are not credit-worthy anyhow.
Lower inflation can trigger faster growth if accompanied by high consumer confidence and a strong investment cycle. But, something radical is required to create these expectations. A game changing revival of “animal spirits” cannot come from the RBI. If it does cut rates, this could trigger another round of bull run. There will be excess liquidity. In the absence of a stronger investment cycle, and higher consumption, that money will flow into equity. The current situation, where a looming debt crisis coincides with a big bull market, seems absurd. But, it could reach even more ridiculous heights for very logical reasons.