Brace for an unusual situation: Inflation amidst a recession

The pandemic has caused the world to go into a deep recession this year. India is no exception. The Indian economy will shrink by about 6% this financial year. Which means that national income will be lower than last year, and every household on an average will have less money to spend. In a recession, demand falls, and so factories remain idle. A lot of the production capacity is unutilised. You can see this across many sectors, including primary ones like steel and cement, or secondary ones like automobiles and washing machines. So, producers are forced to cut prices to boost their sales. Don’t be surprised to see large discounts being offered on consumer durable goods. In a falling demand scenario, we should expect prices to fall, too. Which means inflation should remain benign, right? This does not seem to be bearing out.

It may be true that on certain items, like cars and scooters, or televisions and furniture, large discounts are being offered. But since these price reductions are on discretionary spending items, the demand will still be lukewarm, despite the discounts. Many retailers of consumer goods, both durable and non-durable, make robust business during the Diwali and subsequent holiday shopping season. Some retailers make 60-70% of their annual profit in the months between Dasara and Christmas. That is unlikely to happen this year, since people are cutting back on discretionary spending. When there has been loss of livelihoods, or anxiety about jobs and income, the first thing is to cut back on all non-essential spending. Even weddings, which are a perennial boost to the economy, will be subdued, not just because of the economy, but also to adhere to social distancing needs. If you just keep track of discounts and price drops on such items, you may wrongly conclude that inflation has come down.

The inflation experienced by the common man or woman is based on the items purchased. There has been a marked change in expenditure patterns after the lockdown started in March. These changes may not have been adequately reflected in the basket of consumption goods and services tracked by the government. So, the officially reported consumer price index (CPI) based inflation may be underestimated. Even though it is an imperfect underestimate, the official June inflation was already above 6%, beyond the tolerable band of the Reserve Bank of India. Given that in urban areas many retail outlets, especially malls and restaurants are still shut, the buying pattern has changed considerably. Households may be spending more on food, including processed food eaten at home, and less on eating out, clothes, recreation or travel.

If their food purchases are facing higher prices, this effect can get hidden or understated if we continue to use the pre-Covid consumption basket to compute the CPI. Hence, Professor Alberto Cavallo of Harvard University, used actual data from transactions to compute a “Covid inflation” rate. His research shows that official CPI understates the Covid-CPI inflation in 10 out of 16 countries that he studied. This gap between official CPI and Covid-CPI is widening. His data does not include India. But researchers at the State Bank of India extended Professor Cavallo’s method to India and have found the same phenomenon. That the official number published by the government is an underestimate. For instance, according to SBI research, the actual June inflation could be 7%. And in the severe lockdown months of April and May, it could have been understated by more than 2%.

Truth is, if we focus on items of actual consumption, the inflation trend is worrying. In June, as per official data, food inflation was running at 7.3%. Pulses, which are a key source of proteins, were rising at 16.7% and fish and meat at 16.2%. Milk prices rose at 8.4% in June. The story of milk is interesting. The demand for milk has actually fallen, as per data from Maharashtra. This is because the demand from the hotel and restaurant industry is sharply down, thanks to the lockdown. As a result, milk producers in the state claim that they are receiving Rs 10-15 less per litre than pre-Covid prices. Their stock remains unsold. According to leaders of the farmers’ organisation Swabhimani Shetkari Sanghatana, out of 13 million litres produced daily, around 5.2 million litres remain unsold. And yet, city consumers are facing higher prices for milk delivered at their doorstep. Even the national data on CPI shows milk inflation at above 8%.

In June, we also had a sharp increase in diesel prices, which is used to transport food items. This was an administered price increase of Rs 10 a litre, including central excise and road cess. This, too, will feed into inflation, not just for food products but overall CPI. Despite weak demand, steel companies announced that they were raising prices due to rising input costs. Higher import duties on Chinese goods will feed into overall consumer inflation. Higher levels of non-performing assets, or bad loans, would mean that banks cannot offer lower interest rates on loans. So, the cost of working capital will remain high or go higher. Additionally, the requirements of hygiene, packaging, and safety would also add to the cost of goods. The throughput of sales will also have to be moderated to observe social distancing.

We thus have to brace for an unusual combination of a recession and rising inflation. With loss of incomes, and rising unaffordability, many households may fall back into poverty and even food insecurity. If there is any illness in a family, Covid-related or not, that is an additional shock. The government must be prepared to avert a hunger crisis by vastly expanding the food-grain distribution through the PDS and expanding it to include items like cooking oil and soap, too. Farmers’ income may need to be supported, in case their remuneration for a bumper crop is inadequate. And, of course, a strong fiscal impetus is required to generate demand and jobs and livelihoods.

(The writer is an economist and Senior Fellow, Takshashila Institution)(Syndicate:The Billion Press)