India’s inflation rate has fallen to a six-year low. The RBI now projects inflation to be 2% in the next fiscal year. This is far below recent historical levels of 6% per year. US inflation has also fallen to 3% this year, from a high of 7% in 2021. This is despite a large increase in tariffs.
Inflation has one, and only one, culprit. And that is an increase in the quantity of money in circulation, relative to goods produced. If the amount of money grows faster than the quantity of goods, prices go up. That’s it.
Why budget deficits matter
What causes the amount of money to grow? The only entity that can create money is the central bank. Through their open market operations, central banks buy government bonds. When the fiscal government runs a budget deficit, it issues bonds to make up the shortfall. When central banks buy up these bonds, it adds to the money supply.
Almost all historical episodes of high inflation result from fiscal governments running large deficits, and then central banks creating money to finance those deficits. To understand what drives inflation, we should look at it through this lens.
Why has Indian inflation fallen? The government budget deficit has been falling steadily in the last five years. In 2020, the budget deficit was 9.1% of GDP. In 2024, it was 4.8% of GDP. A steady decline in the deficit means fewer bonds issued, and less new money created. And thus, we have lower inflation.
US tariffs and inflation
Much of the financial press predicted that US tariffs would cause inflation to go up. But the opposite has happened. In fact, tariffs will likely decrease, rather than increase inflation. This is because tariffs are taxes. And higher taxes reduce government budget deficits. Lower budget deficits again mean fewer bonds issued, and less new money created.
Yes, tariffs do raise the price of imported goods. But because they reduce the overall amount of money, demand across the economy falls. This means that prices of other goods will drop. And inflation doesn’t go up.
To be clear, this is not an argument in favor of tariffs. Tariffs have a negative effect on economic activity. In the last five months, Indian exports to the US have dropped 28%, largely due to the 50% tariff rate applied on these goods. India’s GDP growth may have been even higher, were it not for these measures.
The lesson for governments wanting to keep inflation low is to focus on the fiscal deficit. If the fiscal deficit is small, inflation will stay low. Even better if instead of a deficit, the budget is fully balanced. Low inflation creates positive conditions for economic activity and growth.
Low inflation has implications for portfolio returns too. It is good for bonds and stocks, but bad for gold. Gold has had a tremendous run this year. If inflation continues to remain low, gold’s upside is limited, and its downside risk is substantially higher.
Note: The purpose of this article is to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educative purposes only.
Disclosure: The writer does not hold any of the securities discussed in this article.
Asad Dossani is an assistant professor of finance at Colorado State University. His research covers derivatives, forecasting, monetary policy, currencies, and commodities. He has a PhD in Economics. He has previously worked as a research analyst at Equitymaster, and as a financial analyst at Deutsche Bank.