Is the Indian economy staring at stagflation?

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The story so far: The rise in retail price inflation to a nearly six-year high of 7.35% in December has led to growing concerns that the Indian economy may be stagflating. The current rise in retail inflation is mainly due to higher prices for vegetables such as onions. However, the steady rise in inflation figures in recent months in the face of falling economic growth has led to fears of stagflation. Remarkably, former Prime Minister Manmohan Singh wrote in The Hindu had in November warned of the risk of stagflation with a view to the economy.

What is stagflation?

Stagflation is an economic scenario in which an economy faces high inflation and low growth (and high unemployment) at the same time. The Indian economy has seen slow growth in six consecutive quarters since 2018. Economic growth in the second quarter to September, for which data are most recently available, was only 4.5%. Growth of around 5% is expected for the entire year. Most economists have attributed the slowdown to insufficient consumer demand for goods and services. In fact, insufficient demand has been cited as the main reason for the low price inflation that has been prevalent in the economy until recently. The government and many analysts then called on the Reserve Bank of India (RBI) to cut interest rates to boost demand. This created significant tensions between the government and the RBI, which led to several senior officials (including the former RBI governor) leaving the central bank. Finally, under Governor Shaktikanta Das, RBI committed to cut its key rate, the repo rate, five times in 2019.

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The analysts had expected these rate cuts to spur demand and boost the economy. In the second half of 2019, commodity prices began to rise faster due to RBI's rate cuts. However, the growth rate of the economy continued to decline significantly. This combination of rising prices and falling growth has led many to believe that India could slide into stagflation. The only thing currently preventing many from concluding that the economy is completely stagflated may be the fact that core inflation, which excludes items such as vegetables with prices that are too volatile, remains within RBI's target range.

Can economists explain stagflation?

The conventional view of economists is that there is an inverse relationship between economic growth and inflation. The idea was first proposed by New Zealand economist William Phillips, after whom the “Phillips curve” is named, which is based on statistical studies on inflation and unemployment. It later gained broad acceptance among the established economists. The reverse relationship between inflation and unemployment was seen as confirmation of the hypothesis that inflation helps the economy realize its full potential. The logic behind the assumption is that inflation (by increasing nominal wages but not real wages) can, at least in the short term, make workers in an economy accept lower real wages. Without inflation, workers would not want to accept these lower real wages, which in turn would lead to higher unemployment and a decline in economic output. At the same time, economists argue that an inflation rate above a certain level, at which labor and other resources in the economy are fully employed, will have no employment or growth benefits. As a result, policy makers are often advised to maintain a certain rate of inflation to ensure that unemployment is kept to a minimum and the economy is fully utilized. However, the simultaneous existence of high inflation and low economic growth in stagflation challenges the conventional view that inflation helps an economy to operate at full capacity. It was the stagflation in the United States in the 1970s caused by rising oil prices after the organization of the petroleum-exporting countries abruptly cut supplies, which initially prompted many to question the validity of the Phillips curve.

Why is stagflation a problem?

Economists who believe that the current slowdown is due to insufficient consumer demand are prescribing higher government and central bank spending to revitalize the economy. However, stagflation essentially prevents the government and the central bank from taking such countercyclical policies. With private customer inflation now well above the RBI target of 2 to 6%, the central bank is unlikely to support the economy as quickly by lowering the key interest rate. If the central bank decides to add new money to the economy by lowering the key interest rate or using other unconventional means, this could lead to a further increase in prices and worsen the situation. A similar rise in inflation could lead the government to incur deficit spending financed by the RBI. All of this is considered bad news at a time when the economy is underutilized with significant unemployment resources. Stagflation can also be politically costly for the ruling government. On the one hand, the slowdown in growth could affect people's income. On the other hand, higher inflation could lower people's living standards because they can afford less.

Is the Indian economy staring at stagflation?

What is the way out?

The economists are ideologically divided on what needs to be done for an economy to recover from stagflation. Some economists suggest that policymakers should stop worrying about inflation and should instead focus solely on stimulating aggregate demand. India's nominal GDP growth, a measure of total economic spending, is likely to hit a 42-year low of 7.5% this year. They see it as an arbitrary goal of the RBI to prevent inflation from rising by more than 6%, and believe that the central bank should further loosen its political stance and spend more on infrastructure and other sectors to boost the economy.

Read also: What can India do to overcome the global slowdown?

Another point raised by these economists is that broader inflation, measured by core inflation figures, remains within RBI's target range. Core inflation was 3.7% in December. They argue that higher government and RBI spending will not cause inflation levels to get out of control. However, others are more cautious when it comes to advocating a high-spending approach to save the economy from stagflation. They point out that monetary easing only increased prices last year without leading to higher growth rates. A further inflow of liquidity into the economy could therefore trigger higher inflation without boosting economic growth.

Some economists see the sharp drop in consumer demand only as a symptom and not as the main cause of the current slowdown. In this view, it is normal for spending to decline after the credit-fueled boom ends. Notably, India's growth rate has been boosted by the availability of simple loans over the past decade or longer. A further expansion of credit by the central bank and debt-driven government spending, so these economists argue, will not lead to real and sustainable economic growth, but only to another unsustainable boom that will go bankrupt. Instead, they advocate supply-side reforms to achieve real economic growth.