What a rupee buys

There are a number of indicators to show that inflation is on its way down. This is not merely an observation about the backward-looking week-on-week Wholesale Price Index, which has come down to 11.44 per cent and is showing signs of further abating. If we look at the global commodity futures markets we find that the prices of wheat, corn, oil and copper have all declined. Further, it is clear now that the global economy is going to see a significant slowdown. Forecasts for GDP growth in most economies in 2009 have been lowered. Even the fastest growing economies are likely to see a decline in growth. For example, the forecast for GDP growth in China has been lowered by UBS to 8 per cent. High growth in China was seen to be one of the reasons for the sharp increase in commodity prices. With a slowdown in demand it is inevitable that there will be a downward pressure on prices. Prices of steel, iron ore and other metals that are determined in international markets and feed into the WPI are on their way down.

Last year when we witnessed high inflation in India, we saw that it was caused by two factors. One was the increase in global prices. The other was the increase in liquidity caused by the RBI8217;s dollar purchase. Today the situation is exactly the opposite. There is no dollar purchase; indeed, the RBI may be selling dollars, putting the system into a huge liquidity shortage. This will result in a downward pressure on prices.

What about rupee depreciation? In the past we have seen that a depreciation of the rupee has put an upward pressure on prices, so will that not happen again? In the current situation of turmoil, as there is a flight to safety and investors all over the world are buying US treasury bills even at near zero interest rates, there is a huge demand for the dollar and it is appreciating against all floating currencies. Once the panic in financial markets eases, this flight to the dollar is likely to end and the dollar should depreciate. Rupee depreciation should thus be a temporary phenomenon. When this reverses, the upward pressure on prices due to the depreciation will also go away. In other words, all factors indicate that in the next few weeks and months we are likely to see lower inflation.